hedge fund Archives - Algorithmic and Mechanical Forex Strategies

To the average trader, the idea of comparing yourself to a hedge fund may sound a bit absurd. What does a hedge fund, which manages billions upon billions, have in common with your account? Let’s face facts; there are very few of us who have that kind of cash in our trading accounts. Years ago, there was an adage my father taught me, which I believe to this day. That is; “if you can’t measure it, it’s not working.” In business, put another way, if you can’t measure it then it’s probably not worth doing. And really, trading is just like any other business. So if you can’t measure how well your trading strategy is doing, then it’s not working.

Asking the Tough Questions

I’ve been on the receiving end of tons of “advice” on trading and investment – some good, some not so good. My father’s sage advice not only “fits the case” but comes from real world experience. A “measure” forces you to move into the adult world, where you need to ask (and accept the answer to) the tough questions. Do I have a good, sound trading strategy? Am I sticking to the goals I’ve set? Am I taking on too much risk? These are tough questions, and only effective measurements can provide you with the answers.

Why Hedge Funds?

So, why would you measure your trading performance like a hedge fund and not, for instance, an investment portfolio? First, the hedge fund space is the only segment in investment that is the closest to trading. And that is regardless of the hedge fund’s “style.” Furthermore, hedge funds are not limited to a specific strategy. They are usually able to perform and switch positions quickly, just as traders do. In fact, many hedge funds are closer, strategy-wise, to a trader than they are to anything else. As a result, many of the methodologies developed to measure hedge funds are very applicable to trading.

Distribution of Return

The first measure of your strategy should come from distribution of returns. That may sound complicated but it’s really not. Let’s say your strategy is to gain, on average, 100 pips per trade (and no, we’re not holding you to that). If you export your data to a spreadsheet program and measure each, the distribution of your trading profits should stack up fairly close to 100 pips. In order to illustrate we have two examples of profit distribution. In the one on the left you can see Trader A that failed to deliver the target (a gain 100 pips per trade) with widely scattered results. On the right, we can see the trader B has been able to generally earn in most trades very close to 100 pips. That’s an indication that the strategy that was set has indeed worked pretty much as planned.

Sharpe Ratio

The second tool, the Sharpe ratio, is among the most popular ratios around and essentially measures the return per unit of risk. The calculation may sound complicated, but really it’s rather straightforward. It is the average return after deducting the risk free rate divided by the standard deviation of the returns. Now, what does risk free rate mean? When it comes to investments it means the benchmark rate. When it comes to trading, it means the rate you pay on your margin (i.e. your broker’s fee, which could be as high as 7% p.a.).

But here’s the thing; if you trade primarily in the short term, the Sharpe ratio is less relevant. Moreover, since we are talking about many trades per week or month, it would complicate your analysis and would not necessarily yield better results. If you want to compare your trading performance and you trade in the short term, you don’t need to benchmark yourself to interest rates.

So what is a good Sharpe ratio? Well, the text books say a Sharpe ratio above 1 is generally okay while below 1 is considered not that great. From my own experience, however, a Sharpe ratio at 0.8 or above is absolutely fine. For example, if we take the data from the two sample traders above, Trader A would have a -0.4 Sharpe ratio while Trader B would have 1.8.

The Bottom Line

So what’s the bottom line? What can we learn from the two measurements? Two big things. The first; if your strategy is performing, say you planned to gain 100 pips on average and that’s what your distribution shows, then you’re on track. And the Sharpe ratio? If your Sharpe is low your returns are more a reflection of market volatility than your trading strategy. Conversely, the opposite is also true. Of course, there are many more indicators that hedge funds use, but these two will give you the answers to the tough questions every trader needs to ask.

Michael Halls-Moore invited a reply to one of my tweets last week, “Retail traders have an advantage over the pros? Me thinks not.” He wrote a great overview of why the institutional traders look longingly at the retail crowd and all the hoops that they don’t have to jump through.

His points are all valid, but he overlooked the big picture. Pricing is everything to a trader. Retail traders get the short end of the stick when it comes to the cost of doing business.

The cost of trading is massively disproportionate

Let’s say that you’re a would be quantitative trader and that you’re looking for opportunities. Let’s say you trade mini lots in the forex market with 60% accuracy and 1:1 risk reward ratios. If you’re not familiar with what a typical trading system looks like, those numbers means that you have an enormous edge.

Some of the less reputable forex brokers out there charge 3 pip fixed spreads. If you’re trading with a broker offering fixed spreads, I urge you to start price shopping. Fixed spreads are wildly overrated. You pay a huge premium for the certainty of a fixed spread. I can’t think of anything remotely plausible to justify them.

The larger forex brokers charge typical spreads in the neighborhood of 2 pips on the largest majors. Although most seem to find this reasonable, the comparison between a 2 pip average spread and institutional spreads is night and day.

Do you know what the average EURUSD spread looks like on the interbank market? It’s often 0.2-0.5 pips. Retail traders pay an average markup of over 300% on their trades.

Retail traders facing the institutions is a bit like David and Goliath.

Retail forex prices have declined in recent years. A few brokers like MB Trading and Pepperstone offer raw spreads with commissions tied to the dollar volume traded. These are, in my opinion, are about the fairest prices available to low balance traders running an expert advisor.

The best deal available to semi-institutional forex traders (CTAs, large balance retail traders, etc) is Interactive Brokers. The customer support is famously poor; they’re cheap for a reason. IB also offers raw spreads with a commission.

My experience with IB has been excellent, but you need to trade size for the economics to work. A 0.5 pip typical spread is great, but the 2 mini-lot minimum trade size and $2.50 minimum commission really adds up. Trading with IB doesn’t approach institutional type pricing until your average trade size approaches 1 standard lot.

So, how does pricing affect the final outcome with our 1:1 risk reward strategy that wins 60%?

Free trading: After 100 trades, you’ve earned $600 and lost $400. The hypothetical net profit is $200.
Fixed spread: You’ve spent $300 in spread costs to enter 100 trades. The total net profit is -$100 ($200-$300).
Average retail: You’ve spent $200. There is no profit because you breakeven ($200 hypothetical profit – $200 in costs). However, your broker loves you for doing that many trades.
Good retail pricing: Let’s say the average cost of a trade is 1.3 pips after commissions. You’ve spent ~$130 placing 100 trades. The total profit is $70.

Even with good strategies, the profitability of your algorithm is as simple as choosing the cheapest broker.

Equities pricing

Trading stocks is even more expensive than forex. I remember back in the day when I thought Scottrade was cheap for offering $7 commissions. It gets worse and worse when you go through the list of stock brokers. Most of them try to get away with charging $7-10 per trade. If customer service is important to you, then those are the shops to look at.

If your top priority is trading profitably, then again, broker selection is critical. The only way that a small guy can make it is by chipping away at the costs. Interactive brokers is again a great option, charging fractions of a penny per share traded. If you decide to trade 2 shares of Google (GOOG: $1,017 per share) or 1,000 shares of Fannie Mae (FNMA: $2.35 per share), the transaction costs are tiny. Two ticks in your favor is all it takes to cover the trade.

You might be thinking that I said two ticks in forex is expensive. How can I say that two ticks in equities is reasonable?

Volatility. Two ticks in the stock market is a little hiccup. It’s not at all uncommon to see highly liquid stocks move 2-3% in a single day. Forex is only interesting because of the leverage. The currency pairs themselves rarely move more than 1%, and that’s usually on major news.

Risk Management

Every employee knows that they’re only one mistake away from getting fired. That’s the reason that everyone hates having a boss. There’s a single person with unilateral authority to financially murder you. Who’s going to look upon that as a good thing?

Well, the truth is that bosses exist for a reason. It’s someone that calls you out when you do something stupid. More importantly, the boss has the power and influence to ensure that you stop doing stupid things.

The dream of entrepreneurship is not having a boss. You go on vacation when you can, you don’t have to play office politics, you don’t have to waste time selling good ideas. You just go out and do them.

Even with good strategies, the profitability of your algorithm is as simple as choosing the cheapest broker

I can tell you as a small business owner that the negatives stand out strongly in my mind. When you don’t have someone to hold you accountable, even if it’s a mentor, you make many more dumb mistakes than you should. It takes incredible discipline to hold the line consistently. Knowing that I’m not going to look stupid or have to explain myself to anyone probably gives me a lot more false confidence than I really need.

Self-employed traders working at home experience the same thing. Who calls you out when you’re trading just because you’re bored?

The decline in the trading account points out the obvious, but that’s not enough to necessarily stop the bad behavior. We’re social creatures. Most people need to speak with other people to maintain their sanity. When you’re trading at home alone, it takes a lot of effort to ensure that you’re getting enough social contact. A good boss prevents you from indulging in bad behaviors.

Conclusion

Selecting the right broker is enough to determine whether or not a good strategy will wind up making money or not. It’s expensive to trade. The bigger you are, the better your pricing.

Retail trading prices have reached a point where it’s at least possible to trade profitably. Nonetheless, the number of strategy types out there is limited because the lower, shorter term strategies are prohibitively expensive to trade.

The quantitative traders and hedge funds get the more active strategy space to themselves. Their trading costs are so low that they’re really the only people that can afford to trade actively.

Measure Yourself as a Hedge Fund