Pay Attention to These 3 Factors
Pay Attention to These 3 Factors
| Hey , |
| In your trading strategy there are 3 key factors you need to pay close attention to. We call these the 3 Pillars of Trading Performance. Let’s dig into what they are and how to optimize them to increase your P&L. |
| Pillar #1 – Edge Edge is a concept that decades of trading literature have beaten to a pulp. You’ve heard it a million times: “You need a positive edge to win long-term.” And it’s absolutely true. In trading, edge is your ability to select trades that perform better than random. You can think of edge as the process used to generate and execute entry and exit signals. Professional traders spend a majority of their time on this process alone. They’re constantly asking themselves questions like: * How can I refine my research to enter the absolute best fundamental plays? * How can I better time my exits and entries using quantitative cues? * How can I cut my losses through improved exit parameters? The more they improve their entry and exit signals, the stronger their edge becomes. To increase your own edge, relentlessly search for holes to plug in your trading process. This could involve a stronger focus on improving your fundamental analysis. Or maybe refining your profit taking approach. It could also mean tighter risk management or really any number of other factors that go into an effective trading strategy. The stronger your edge, the more profitable you’ll be. Pillar #2 – Frequency Frequency refers to the amount of times your edge expresses itself in the market. HFT firms may see a million opportunities a day to exploit their edge. A deep value manager, on the other hand, may only see his edge show up a few times a year. Frequency matters because the more opportunities you have to apply your edge, the higher your earning potential that year. Ideally you want to apply your edge as many times as possible. But of course keep in mind that the optimal frequency will differ between strategies. If you expect to increase the frequency of your deep value strategy to a million opportunities a day, you’re out of your mind. At that point you’ll be investing in everything and anything, with the concept of “value” thrown out the window. This is where frequency can become a double-edged sword. The key is to increase it in a way that does not degrade edge. Few people think about the trading process from the frequency angle. They tend to focus only on cultivating an edge, but never give any thought to how often that edge can be executed. Look at your own trading process. * What type of edge are you developing? * Is its frequency optimal for your particular strategy? For example, if you’re a deep value investor, are you looking at as many markets as you could be to find the best deals? If you’re only investing in US equities, would a trip into the foreign markets increase the frequency of the value propositions you’re able to find? The more often you apply your edge, the more money you can extract from Mr. Market. Pillar #3 – Leverage Leverage, like frequency, is rarely discussed, yet extremely important. It can mean the difference between average and superior performance. Leverage simply means deploying extra capital above your cash level in the market. Now a lot of people will tell you that using things like margin to add leverage to your trades is dangerous. And that may well be true for beginners, but proper use of leverage for a professional is essential to their success. Soros’ Quantum fund would routinely achieve leverage levels of 4 to 1. That means that for every million dollars in their account, Soros and Druck had 4 million in bets out in the market. If you want to blow the doors off the average performance you see in the market, you need to focus on increasing your leverage as much as possible. Now the obvious caveat to this statement is that you should never press your leverage to a point where you risk bankruptcy. A proper risk management system will tell you the max amount of leverage you can apply per trade without going broke. For example, don’t trade a 10 lot of E-minis on a $10,000 account. That would not be wise… Intelligent uses of leverage are critical because they not only increase returns, but they can actually reduce overall portfolio risk too. Ray Dalio was one of the first investors to popularize this concept (also known as risk parity). * Say Asset A returns 5% a year above the cash rate, with a volatility of 7%. * And Asset B returns 15% a year above the cash rate, but with a volatility of 30%. Which is the better deal? If you can’t apply leverage, and you want to make more than 5% a year, then you’re forced to go with Asset B. But if you understand how to apply leverage, you could easily lever up 3 to 1 (borrow 3 units for every 1 unit you own). This would allow you to buy 4 units of Asset A instead of 1, transforming your returns to 20% a year with 28% volatility — a much better deal than Asset B’s 15% a year with 30% volatility. Creative uses of leverage in your investment strategy will put you leagues above other investors without leverage. An Optimization Problem Once you understand the 3 pillars of trading performance, your goal should be to maximize each: * Maximizing your edge means winning more and winning larger. * Maximizing your frequency means applying that edge more often. * And maximizing your leverage means juicing your capital base. But here’s where it gets tricky. You can’t blindly maximize each pillar individually. You’ll end up destroying your strategy and landing yourself in the poorhouse. The problem is that each pillar affects the other. Adjusting one leads to a change in another. Say for example you decide to lengthen your investment timeframes. You believe higher time frames have less noise and stronger signals. Great! You end up increasing your expected value per trade through a larger edge. But before you run off to raise a few hundred million, you need to consider what you’re giving up to achieve that higher edge. The answer is that you’re giving up your frequency. If you make $2 a trade on higher timeframe monthly charts, which provide a frequency of 25 trades a year, you’ll make 50 bucks. But what if that same strategy on lower timeframe daily charts made $.50 a trade, with a frequency of 200 trades a year? The daily program, despite the lower edge (profit per trade) would generate $100 a year in profits. That’s twice the returns of the higher timeframe strategy! In this case the strategy with the smaller edge actually makes more money per year. This is why those pesky HFT’s do what they do. Yes, smaller timeframes are noisy, making it harder to create a meaningful edge, but if that smaller edge has a higher frequency than a larger edge, then it may actually be optimal. This is why optimization becomes difficult. You can beef up your edge by adding more criteria or filters to produce a better signal, but by being more selective, you decrease the frequency of your entries. So it may actually not be in your best interest to beef up your edge… The next time you approach your trading process, go at it with the 3 pillar optimization problem in mind: * How can I increase the expected profitability (edge) of each of my trades? * How can I optimize my trade frequency? * How can I leverage my current capital? And when it comes to optimization: * Are the three pillars of my strategy flexible? * If so, can I manipulate one and still come out with a juiced up bottom line? Start to look at your trading process from a multi-dimensional point of view. Focusing on improving a particular setup or exit methodology is good and all, but that’s just one part of the puzzle. It’s playing a 2-D game. You need to look 3D and beyond… An Optimized Macro Process At Macro Ops we apply these 3 pillars of performance to our Global Macro strategy. A Global Macro strategy captures opportunities arising from macroeconomic and geopolitical events. This could be anything from changes in government policies and economic trends, to shifts in global trade and currency values. Here’s how we apply the 3 pillars: Pillar #1: A Strong Edge Global Macro has one of the most robust edges of any strategy because of its ability to adapt to every market scenario. While other strategies fall apart when the market environment shifts, this strategy actually benefits from the volatility. Pillar #2: Frequency Global Macro will help you exploit opportunities across every global asset class including equities, bonds, commodities, and currencies. This freedom vastly increases the number of profitable trades you can make per year, allowing you to express your edge at a much greater frequency and transform your bottom line. Pillar #3: Leverage By understanding the macro landscape, we’re able to identify critical shifts in market behavior. This allows us to size up when the getting’s good and play it safe when markets get shaky. And because of our access to futures and currencies, we have precise control over how much leverage to use to maximize our returns. If you want to start using a Global Macro strategy in your investment process, then make sure to check out the MO Collective where our members have complete access to our specific macro process, tools, and much more. The Collective is our premium global macro service that offers institutional-level research, proprietary quant tools, actionable investment strategies, and a killer community of dedicated investors and fund managers from around the world. You can learn more about the Collective and how it can upgrade your investment process here. Enrollment opens next week on Monday, July 24th and will remain open until Sunday, July 30th. And if you prefer to talk to us directly, you can schedule a free consultation call by clicking the link below: Click here to schedule your call. |
– The MO Team |
Thanks for reading.
Stay frosty and keep your head on a swivel.
| Your Macro Operator, Alex Barrow https://macro-ops.com |
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