Saturday, 27 February 2016

Miami twice as bearish

15:26 Posted by The Thalesians (@thalesians) 1 comment

So why did the title of this article include the words "Miami twice"? I suppose it does sound like the TV show Miami Vice (well, actually that was the main reason). I can't remember much about the show aside from the white suits, sunglasses and the 80s music, perhaps because, I was always much more a fan of the A-Team during that decade of shoulder pads and forgettable music. 

Before I visited Miami over the past week, I already had this vague image in my head of what to expect: the smell of oranges, the sight of the sea and the sound of Spanish, all somehow coalesced into a single snapshot, with the backdrop of whitewashed Art Deco buildings straddling the image. What I had not quite anticipated, was the serenity of the sunrise casting its shifting gaze over the beach. If you ever do go to Miami, I strongly recommend waking up earlier than you might ordinarily do to witness this.

Much of my time, however, was spent inside at the TradeTech USA FX conference, rather than watching the waves roll on beneath the sun. Whilst the sun was shining outside, the mood inside the conference was perhaps less than shining. A bearish mood pervaded most of the conversations during the conference. This was perhaps not unique to conference. In general, within the market, there seems to be a general perception that we've reached a stage where central banks are out of rope, epitomised by the move negative rates, the latest stage of easing. The recent market reaction following the BoJ's move to negative rates seems to tally with this. One interesting point raised by Steven Englander from Citi, during his conference presentation, was that potentially the markets have underestimated the creativity of central banks in coming up with solutions. 

To some extent, I have to agree with Steven's point, particularly when we consider how central banks have reacted following the financial crisis. They have been somewhat more creative than they were during previous crises, notably following the Great Depression. At present, it has become quite fashionable to be outright bearish. The market can often be "right" and it's a reason why trend following is a profitable strategy and why long only strategies have historically been profitable, albeit with some volatility. However, once the cacophony of market bearishness becomes overwhelming, the risks have evolved from being a black swan style event to merely a grey swan type of event and potentially the market will have overpriced the event. If everyone is expecting a disaster, then arguably market positioning will be skewed that way and if anything any "good" news can result in a nasty squeeze the other way. Insurance is most valuable when the market does not really agree about an event, whether it is in the nature of that event or the timing.

One example of this can be seen in Brexit. We of course do not know with certainty the outcome of the event. What we do know, is the timing of the referendum. Hence, knowing the timing means, we can hedge this risk. The likely risk premium which will seep into the market is likely to increase over time, as investors seek to protect themselves from an adverse outcome. Given it is risk that we can hedge, the temptation is for the market to end up overpaying for protection or having an extended exposure in the cash markets. Hence, even if there is a bad result, the risk premium will be so high that it is unlikely to be the case that a hedge would work. It's like buying a Ferrari and having such expensive insurance, that it ends up being the case that the cost of insurance makes up a large proportion of the cost of the car.

Planning for the expected, is perhaps not as important as planning for the unexpected when it comes to hedges. As Hannibal from the A-Team might say "I love it when a plan comes together".

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interested in me writing something for you or creating a systematic trading strategy for you! Please also come to our regular finance talks in London, New York, Budapest, Prague, Frankfurt, Zurich & San Francisco - join our Meetup.com group for more details here (Thalesians calendar below)

29 Feb - London - Jessica James - FX option trading
14 Mar - San Francisco - Quant Fintech Mixer Event
15 Mar - New York - Thalesians/IAQF - Alex Lipton - Modern Monetary Circuit Theory
21 Mar - London - Robin Hanson - Robin Hanson, Economics when robots rule the Earth
20 Apr - London - Oskar Mencer - FRTB, RWA, XVA, Scenarios, MiFiD II, fast?
13 May - Budapest - Saeed Amen/Paul Bilokon - Thalesians workshop on algo trading at Global Derivatives

Saturday, 13 February 2016

Fashion, trends and CTA strategies

17:12 Posted by The Thalesians (@thalesians) 1 comment

I'll confess, understanding fashion has never been my strong point. My uniform for much of my career working in investment banks was simply an ill fitting suit. I eventually worked out that a suit, which was the right size, might actually be a good idea. In recent years, since quitting banking, working as a full time quant strategist at the Thalesians, my uniform has been the humble t-shirt and jeans. I shall leave that up to you to decide whether I possess a modicum of dress sense....

Despite that, the little that I do know about fashion is that trends play a big part in it. If some such celebrity, who I probably don't know the identify of, suddenly wears an item of unusual clothing, it becomes "trendy" to wear it. If an item appears on the catwalk, high street brands will scramble to produce similar items, and then suddenly everyone is wearing it. Fashion trends seem infectious. Then after a while people tire of a fashion and the trend is extinguished. Fashions move in cycles, punctuated by the seasons, items of clothing seem to come in and out of fashion decade after decade.

Trends are obviously not purely restricted to fashion. Markets exhibit trends. There's that hot IPO, which has attracted lots of media interest, that market participants are desperate to get hold of. There's that new startup, which no one cared about, until a few big venture capital funds decided to invest. There's that currency that was languishing near the lows, till a smart hedge fund manager decided to buy, precipitating interest in that currency, from the rest of the market. We see an asset trend upwards on a chart, and suddenly, human behaviour gets involved and we want to buy, we don't want to miss that move! I could give countless examples of this type of herd behaviour in markets, which mirrors that we see in fashion. We all claim to be immune from it, yet, the fact that there are trends in the market seems to say otherwise.

Even if we ignore the behavioural argument for trends, the presence of an economic cycle gives rise to market trends. At the beginning of an economic cycle, we might expect materials stocks to outperform, as companies begin to invest in infrastructure. Countries which export commodities also tend to benefit. As the economic cycle wanes, commodities become less bid, and investors shift towards preservation of capital as the recession approaches, shifting from equities towards bonds.

Whilst the old maxim says "buy low, sell high", to be a trend follower in markets, you do precisely the opposite. You buy high, on an expectation of price action going higher. Conversely, you sell low, expecting the price to continue drifting lower. CTA, or commodity trading advisors have been around for around for decades. Typically they use systematic trading models, which are trend following, to make trading decisions. But how precisely do they go about it? At Global Derivatives in May, which will be in Budapest for the very first time, I'll be presenting my paper "How to build a CTA?" to help answer this!

I'll be examining the various technical indicators which can be used to generate trend following signals. I'll also be showing, how trading multiple asset classes from a trend following perspective can improve risk adjusted returns, compared to focusing on a single asset class. I'll be looking at historical results which show how trend following can help diversify the returns of long only equity and bond investors. To round off the discussion, there will be an interactive demo of how to implement a simple FX CTA type strategy in Python using my open source PyThalesians library (download the code from GitHub here).

If you want to know more about what a CTA does, hopefully see you at my talk at Global Derivatives in May! I promise I won't be attempting to tell you about my fashion sense at the same time....

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interested in me writing something for you or creating a systematic trading strategy for you! Please also come to our regular finance talks in London, New York, Budapest, Prague, Frankfurt, Zurich & San Francisco - join our Meetup.com group for more details here (Thalesians calendar below)

16 Feb - New York - Thalesians/IAQF - Harry Mamaysky - Does Unusual News Forecast Market Stress?
29 Feb - London - Jessica James - FX option trading
14 Mar - San Francisco - Quant Fintech Mixer Event
15 Mar - New York - Thalesians/IAQF - Alex Lipton - Modern Monetary Circuit Theory
21 Mar - London - Robin Hanson - Robin Hanson, Economics when robots rule the Earth
20 Apr - London - Oskar Mencer - FRTB, RWA, XVA, Scenarios, MiFiD II, fast?
13 May - Budapest - Saeed Amen/Paul Bilokon - Thalesians workshop on algo trading at Global Derivatives