My Hedged Fund - Another "Trend-Following" Post

[JRP2891]

I would second that. I read a report on the web once (can't find it now) which examined how systematic funds occasionally underperformed the market, but when that happened it was usually time to invest in them.

Obviously this is all a bit anecdotal in the sense that just because you have 7 losses in a row, doesn't mean you can't have another 7 losses in a row .. but generally this doesn't tend to happen.

Yes, that's what all these funds advise you to do; invest on a drawdown, not at the highs. I know when i add any funds to my trading capital nowadays it's when i'm down 15-20%, i learnt the hard way!

That's right, when randomness is at work you might get another 7 losses after the first 7. I've never experienced that myself, but it will probably happen at some point. My edit above was to add the significance, in my view, of the bad run of losses during an extended drawdown. That is generally the time i want to be even more committed to making sure i'm at my desk taking the next trades. The sharp losses in equity after a month or 2 of choppy trading conditions are a bit of a beacon to myself, although you of course never know for sure until after the fact.

 

[meanreversion]

One of the chaps I trade with is what I call an "armageddonist", he's convinced we're about to enter phase 2 of the credit crunch, with sovereign bond yields (US, UK, Germany and Japan) about to spike.

It's not clear to me that if (for example) US yields start powering higher, that the USD comes under pressure. If anything, higher USD yields in the past have usually presaged a rise in the USD. I've got the 10yr T-note amongst my markets so if that does go off on a tear, I'll have something on it.

For me, this is the attraction of a purely mechanical system.. it's possible to argue any point of view but in the end, who knows? Most Western traders have been bearish on JGBs for about ten years, and they've done nothing but go up.

At any rate, I feel as though we have the ingredients in place for decent moves in 2011.. I stilll fancy the euro back to parity but it's more resilient than a cockroach in a toilet sometimes.

 

[JRP2891]

For the reasons you mention, i also prefer a predominantly mechanical approach, and also your system will get you in the trades which you don't want to take. Price really is the only thing you can trust, oh and also that human's won't change.

A strengthening dollar would catch a lot off guard i think, probably the greatest potential perception change. That'll test the resilience of the cockroach.

 

[myhedgedfund]

That's one big long position with A LOT of energy bought at new highs. Not saying it can't go higher but the high and recent energy prices are very well known to all market participants.

Also, where's the 'hedged' part as in 'My Hedged Fund'?

Fair questions Anley.

Am I "too heavy" on Energy? There are two answers to that, one based on raw data, the other based on the actual theory behind the "Trend Following Strategy." Here they are:

- The raw data - So your statement made me curious, because like you, I had "sensed" a significant investment in Energy ETF's. The data shows that I have $23K in ERX (leveraged Energy), $8K in FCG (Natural Gas), $8K in IYE (Energy), $8K in KOL (Coal), $8K in NLR (Nuclear) and $8K in XOP (Oil & Gas Exploration). The total is $62,172, out of a potential ~$305,000 for a 20% total investment in Energy ETF's. May be a tad high, but not to a level that worries me. (Anley, do you have a max investment in any sector? If so, what is it?)
- The better answer - I may not care. Trading using trend following techniques is after all about buying "buying high" and "selling low." While I would tend to avoid concentrated exposures to any one market / asset, if the trend is strong (as with Energy right now), I may not mind getting heavy on it. In a strongly trading market, I don't fight it, but carefully ride it. I am of course keenly aware that the trend may turn against me at any time (on Energy and all other assets by the way), and I'm ready to sell as soon as that happens.



Where is the "Hedge" in "My Hedged Fund"? This, honestly, is a great question Anley and I will add this reply to my blog. Here are my thoughts on the topic:

Hedging as typically defined is a strategy which, if effectively implemented, should remain profitable and be protected from unanticipated market turns by having exposures on both the Long and Short sides of the market. By conducting what is often referred to as "pairs trade," the investor seeks profit by buying a Long position while reducing the overall market risk exposure by hedging (selling) against it.

Example - Someone following this strategy would, for example, buy Sanofi-Aventis because he feels the company has a bright future, but sell Novo-Nordisk (assuming he feels its future is not as bright) at the same time to hedge against market risk. If the market trends up in general, the Sanofi investment will go higher than Novo's (assuming the stock selection was accurate), and the Long gains will be greater than the Short losses; the investor wins. If the market trends down in general, the Sanofi investment will go down less than Novo's, and the Short gains will be greater than the Long losses; the investor wins.


Now, not all hedge funds look to be market or beta neutral; "Hedging" has other definitions, and no surprise here, one of those "other" definitions is the one I subscribe to. Some hedge funds strategies are dependent on pure market direction and are thus "directional bets." Strategies such as "global macro" (the one I use) are particularly directional, seeking to capture macro trends (in my opinion trend following at its best.)

What I do is try to identify as many ETF tradeable trends as I can (currency, commodities, Indices, and yes shorts) and structure a portfolio of multiple directional bets to capture them. Though this investment is not classically hedged, the sum of the total instruments should diversify my risks such that the performance of the portfolio is not highly correlated (and therefore hedged) to the general markets.


The reader who's interested in a more in depth discussion of the topic is directed to "Do It Yourself Hedge Funds" (OK, so I did not come up with the title) by Wayne P. Weddington, who touches on these topics with some depth.

 

[myhedgedfund]

Your rule 3 states this -

Be patient with winning trades; once a trade is put on, give it time to work, give it time to insulate itself from random noise. Be enormously impatient with losing trades, small loses and quick losses are the best losses.

My question is this -

Say you buy something on Monday and it goes down on Tuesday and Wed and even Thursday how will you determine whether to give the losing position 'time to work' because the 3-4 day downmove might be random versus 'being enormously impatient with losing trades, small loses and quick losses are the best losses.'

I'm not trying to be a smart dick but that rule 3 looks like it's going to hinder your trading far more than it helps because it contradicts itself. In effect you'll only know after the fact whether to give the trade the room it needed (assume your timing will always be slightly off) or whether it was right to cut it very quickly.

I read this rule differently. If I buy today, and the position goes against me immediately (say a week-long downtrend), the system will likely instruct me to get out. I must be impatient, not question the system, and get out. If I buy today, and the position works for me for weeks on end, a week-long downtrend is unlikely to result in the system telling me to get out. I must trust the system and be patient with that winning trade.

Matter of interpretation I guess.

 

[myhedgedfund]

Another question I would have for you is this -- by whichever metric you use to enter long positions, would all your longs have been in place had you started a month earlier? Or two months earlier?

The way I operate is if I add a new market, it may already be "long" by the system rules, so I need to wait until it is "naturally" stopped out before looking for a new signal to go long.

In other words, if I was starting a trend fund on Jan 1st, unless the market retraces a few percent, I would be waiting a while to establish my first trade.

You are correct. Each and every one of my positions would have been in place before this past week; those positions were actually all "in," I just reallocated them this past week. That said, and with the way I operate, if cash becomes available, and a market is already "long," I go long. In other words, I do not wait until the position is "naturally" stopped out before going long.

 

[myhedgedfund]

It's also interesting that you've got a discretionary element in there. In my opinion you should keep the technical/trend elements separate from any "views" you may have on the market as they are at completely different ends of the investment strategy spectrum

I agree with your opinion in its entirety... it was the logic behind the "Fundamentals" write-up. Which discretionary element are you referring to? I'd like to remove it as quickly as I can...

 

[myhedgedfund]

Having read Boston's rules, the only one i'd have a mental conflict with would be no.6; When sharp losses in equity are experienced, take some time off. Many traders employ this rule and I can see why you would if you're mainly a discretionary trader. However in my experience of trading a medium term FX trending strategy, sharp losses in equity more often than not immediately precede opportunities to position yourself in the early stages of trends, as the markets become less cluttered due to the weeding out process that naturally has to occur. Could this rule actually end up costing you more Boston? I know when i've had 6/7 losses in a row as part of a more prolonged drawdown, i start to get a bit excited (weird i know), because usually good things start to happen if you keep taking your trades.

Very good point. I bought into this rule thinking that under a "sharp loss" condition, one could be tempted to tinker with the system... question or interpret its signals. Rather than taking such a risk, it would be best to "temporarily withdraw." This is not a good rule, for a couple of reasons. It is discretionary as Adamscj stated (how sharp is sharp?), it does not outline when to get back in and it takes you out when experience tells us the turnaround is about to come.

I have never made use of the rule, meaning I have never gotten out because of sharp losses, and it makes no sense to keep it in. I'll remove it from the "Trading Rules."

On that topic, any "rules" you care to share?

 

[meanreversion]

You're long nat gas? It looks like a huge downtrend to me.. what is your criteria for determining trend?

 

[anley]

MHF

Thanks for replying to all our points, believe me I and I think the others aren't trying to goad you.

Back to your hedging part, you say you will trade some shorts against longs, I understand that but where are your shorts? Or are some of those ETFs short ones (although they're bought)?

 

[isatrader]

You're long nat gas? It looks like a huge downtrend to me.. what is your criteria for determining trend?

He said he has $8K in FCG, which I just looked at and is First Trust ISE Revere Natural Gas (ETF). Is not a pure play on natural gas, but a fund index that is an equal-weighted index consisting of exchange-listed companies that derive a substantial portion of their revenues from the exploration and production of natural gas. Looks like it had a low of $8.60 in March 09 and is now at $19.65. So looks like he’s done pretty well out of it.

 

[adamscj]

I agree with your opinion in its entirety... it was the logic behind the "Fundamentals" write-up. Which discretionary element are you referring to? I'd like to remove it as quickly as I can...

Sorry I mis-interpreted your fundamentals write up, I thought this was somehow being factored into your TF strategy. After re-reading I realise was something else entirely

 

[JRP2891]

Very good point. I bought into this rule thinking that under a "sharp loss" condition, one could be tempted to tinker with the system... question or interpret its signals. Rather than taking such a risk, it would be best to "temporarily withdraw." This is not a good rule, for a couple of reasons. It is discretionary as Adamscj stated (how sharp is sharp?), it does not outline when to get back in and it takes you out when experience tells us the turnaround is about to come.

I have never made use of the rule, meaning I have never gotten out because of sharp losses, and it makes no sense to keep it in. I'll remove it from the "Trading Rules."

On that topic, any "rules" you care to share?

Well, the only rule i have regarding this topic, is to keep taking my trades regardless of the number of losses i've experienced before. I deem the risk of not taking one of my method's trades to be infinitely larger than taking another small loss if it doesn't work out.

 

[meanreversion]

Well, the only rule i have regarding this topic, is to keep taking my trades regardless of the number of losses i've experienced before. I deem the risk of not taking one of my method's trades to be infinitely larger than taking another small loss if it doesn't work out.

We've obviously been on a similar path. I tried getting cute with some signals last year, and it ended up costing about 10% of my equity in P/L. There were two big bloopers - not taking an AUD long signal just before it rallied 10% in spot, and not taking a sugar long signal, shortly prior to a 20% rally.

There were a few occasions when I skipped signals and it saved money, but the overall effect was sharply negative.

What I would say is that I have no issue with modifying the strategy from time to time. You can't possibly know everything on day 1, so it's only natural that (subtle) alterations will be made along the way. As an extreme example, the Turtles changed their channel daycount when brokers cottoned on to the system and started jamming their stops. I've made a couple of modifications in the last six months, one of which is to include a drawdown limit. I also threw one market out (CAD) and brought in the 10yr T-note, to achieve (I believe) a better balance.

But by far and away the biggest issue is in not taking entry signals, it's imperative to take them all.

 

[adamscj]

But by far and away the biggest issue is in not taking entry signals, it's imperative to take them all.

That's why I prefer a trading a continuous signal rather than defined entry/exit rules for a TF strategy - it prevents you being tempted to second guess your own rules!

 

[meanreversion]

Does that entail (potentially) daily re-balancing of the portfolio?

 

[adamscj]

Does that entail (potentially) daily re-balancing of the portfolio?

in theory yes, although in practice you'll round the target position to the nearest lot/contract of whatever you're trading so you'll end up staying constant for a fair amount of time. You'll see this in action if you check out the s/s I sent over - whilst the raw signal changes daily, the ContractPos is a lot more stable. The net result it a big saving in trading costs at the expense of tracking error to the underlying strategy.

 

[meanreversion]

It's an interesting idea, one I'd not come across before.

My background is not IT but I did manage to code up an algo to trade a short term FX system. I could in theory extend it for the medium term system, but all trades there are done in futures (including FX). Where I come unstuck with trying to code algos for futures is the non-standard and sometimes changing contract names.. also, there is the occasional roll which has to be manually executed.. this complicates matters further. As the medium term system is low frequency (10-15 trades/month), I enter/modify orders manually each morning.

I use a Donchian channel for breakouts.. I've looked at moving averages and Bollinger bands, but for me the advantage of using a channel is placing orders in the morning and forgetting about it. With MA or Bollinger, you're then faced with the issue of having to (attempt to) trade on the close or immediately on the open, which is not something I would be comfortable with on a daily basis (i.e. I don't want to be up at 11pm each night dealing in thin markets..!).

Is your system fully automated, and what time of the day does it re-balance?

 

[adamscj]

I thin I mentioned before, I've got 2 completely independent systems.

The first is for intraday (3~5 trades per day) FX and for this one I've coded up my own application that subscribes to market data, calculates a few signals and then can automatically place a trade. This is only running in Demo at the moment.

The second one is the longer term trend following running G7 (ish) and most relevant to this thread. As this only uses daily data I do everything in Excel and trade manually. I'll take a price at a fixed time of day (4pm), enter into Excel, compute the new signal and trade the difference if necessary. The whole process for a few currencies takes 2/3mins so I just accept the time risk

 

[meanreversion]

Have a look at Amibroker, $280 one off fee. You can do absolutely anything you want from it, backtesting, algos, statistical analysis, etc. Gets round having to use Excel.