Getting Started

Below we look at the key choices that need to be made before embarking on the development of a  trading strategy.

Investment Objective

Success for an investor can be defined in one of two ways: consistent performance or consistent outperformance. The two are not the same thing. A fund manager whose results are judged against the S&P500 will be delighted if his fund increased in value by 20% when the market was up only 10%. Similarly, he will be judged favorably if his fund only lost 10% when the market lost 20%. The fund has consistently outperformed the market, although it not consistently made money.

The typical short-term investor is less interested in consistent outperformance as he is in consistent performance. The individual who trades for a living, or the money manager who needs to show consistent quarterly results, will be happy to make only 10% when the market makes 20% provided he can also make 10% when the market loses 20%. Those seeking consistent returns will therefore gravitate towards strategies that hold the promise of making money in both good times and bad.

Both consistent performance and outperformance are legitimate objectives. They key is to decide what one is striving for and commit to it. With that done, the relevant R&D can be undertaken, and the right time-frames and investment vehicles can be selected to achieve the desired goal.

Timeframe

Trading edges in capital market time series exist in all timeframes. This explains why some traders are able to make a living scalping the markets or exploiting intra-day strategies, be they statistical systems or execution-based systems. Other traders prefer longer holding periods, possibly more adapted to their trading style and techniques.

The risk associated with any trading position rises in a linear manner with the passing of time. The longer a trader holds a position, the higher the chances the market will move against him and the greater the magnitude of potential losses.

The trade reward proposition, however, does not increase in a linear manner. Day-trading provides only modest profit potential due to both the limited intra-day trading range and the relatively high costs of commissions and slippage. Longer-term systems that trade over several weeks offer much greater profit potential while incurring more modest relative trading costs. However, statistical trading edges all have finite lifecycles – peaking at what are known as “sweet-spots” – and holding positions too long simply increases risk while adding little or no potential incremental return.

The choice of investment timeframe is usually dictated by the choice of investment objective. Those looking for consistent performance will typically focus on shorter-term systems (algorithmic trading, momentum, mean-reversion, etc), while those simply looking to consistently beat the market will gravitate towards longer-term investment strategies (trend-following, stock picking, pair trading, etc).

Market

The financial markets span a large number of investment categories including stocks, bonds, commodities, foreign exchange, money markets, insurance markets and derivatives markets. Of these, only four are within easy reach of the retail investor: namely stocks, commodities, FX and (to a lesser degree) bonds.

Selecting a financial market is of course a function of the trader/investor’s objectives, experience and trading style. Foreign exchange markets with their high trading volumes and 24/7 opening hours tend to attract short-term speculators and algorithmic hedge funds. The commodity market is more conservative and tends to attract mid to long-term investors or those seeking “legitimate” market hedges. The bond market is probably the largest of them all, but presents some considerable barriers to entry for the average retail trader. Finally, the equities market, which offers a high volume and low fee environment for the short-term trader, plus potential capital appreciation and dividends for the long-term investor, represents an attractive proposition for both traders and investors alike.

Instrument

There exist a multitude of possible investment vehicles – individual stocks, options, commodity futures, index futures, countless foreign exchange pairs, ETFs, etc – each with their respective advantages and disadvantages. The main factors one should look at  when selecting a trading instrument are:

Relevance : does this instrument fit my trading/investment plan?
Trading volume : is the instrument liquid? Will I always be able to find a buyer or seller and transact at a “fair price”?
Bid/ask spread and slippage : what is the typical bid/ask spread? How much will it cost me to enter/exit a position?
Commissions & Fees : what is the cost of a round-trip transaction?
Margin & Leverage : what leverage can I use?
Specificities : what are the unique features of this product (dividends, option expiration dates, etc)

The most attractive instruments are typically those offering the highest daily transaction volumes, lowest bid/ask spreads and fairly predictable slippage values. Examples of these would be the USD/EUR pair (foreign exchange), the ES contract (index futures), and the SPY (ETF).