Mostly running a systematic trading strategy is dull. Occasionally however something interesting happens. Here is a tale of two positions. One went well, the other badly. Examining these will also allow you to see 'under the hood' of my trading strategy, which you might find interesting. Also it illustrates the kind of diagnostics you need to have available on a systematic system (though there will be a longer post on this in my continuing series). The last few weeks in the Agricultural markets have seen a pretty wild ride. I found this headline interesting "Commodities jump most since february as corn, soybeans rally". I found it interesting not because I'm interested in weather reports from the US Mid-West, but because I am long soybeans, and short corn. Sure enough when I looked at my p&l for the last couple of weeks it was dominated by a large profit in soy; and a big loss in Corn. But that is jumping ahead. Let's start by looking at why I had these positions on. More on my blog
Common knowledge is that grains are highly correlated. A sophisticated system trader like yourself has probably studied the exact degree of correlation and then some. Don't you feel that having opposing positions within the grain complex would neutralize your exposures and be innefficient use of capital?
I'd love to hear his explaination for why his "system" went short on one grain and long on the other given the fact they had almost the exact same charts.
I don't think you understand what diversification really means. What you did with your corn and soy trade is not diversification. Regards Shelton
Diversification in this context means having trading systems for multiple instruments, which have less than 100% correlation with each other. Some of those trading systems will have very high correlation (but also see my further comments below). But sometimes they will have quite different positions on, which is what gives you the diversification. This is a very interesting point. So let's start from the premise that with enough capital I'd want to trade every liquid instrument in the world. Why? Because diversification is the only free lunch. To put it another way I don't know in advance which of my instruments will make money. So I should hedge my bets by holding as many of them as possible. As long as something has less than 100% correlation with what I'm already trading then with no other constraints I would definitely want to add it, because it's going to improve my risk adjusted return (leaving aside the argument about how stable correlations are). To reiterate the point from above usually I'll have the same bet on in very similar markets; but sometimes I'll have an opposing bet on. Because I leverage up to account for diversification I should (in the long run) end up earning more with the same amount of risk. So at least in this world having offsetting positions isn't a 'waste' of capital. Actually if I have a lot of capital, like a few billion dollars, then I have to trade every liquid instrument. I even have to trade for example both the front, middle and back Eurodollars; even though they are 98% correlated with each other. This is because I can't deploy my capital equal weighted across all the markets that are out there, since in many of them I'd be too large a proportion of the open interest. Note that the correlations of trading systems are lower than the correlations of the actual instruments themselves. If you read the blog you'll see this is partly because (a) you might not use exactly the same system even on highly correlated markets and (b) modest differences in behaviour can translate to larger differences in positions over time. So the correlation of those eurodollar systems might 'only' be 90%. Let's go from the other extreme now. Suppose I have a portfolio that only contains corn, because I only have enough capital for that one future. If I got a bit more money and could only trade two futures it would be crazy to trade both corn and soyabeans. I'd be better off putting my money into corn and say treasuries. As I got more money I'd be better off adding more asset classes. So I'd add maybe Crude, then an equity like S&P500, then maybe Gold, a currency; and then eurodollar and VIX. Only when you reach this point (which is probably a six figure portfolio) would you start to think about adding a second product to each asset class. And again in ags I'd probably add hogs or cattle next, rather than another grain like soyabean. Anyway, you get the idea. At some point it becomes logical to trade both corn and soyabeans (and I also have wheat). I've reached that point. I was also curious about this which is why I dug into it and posted the topic originally. Read the blog, which has the explanation in it. I'd love to hear why you feel the need to use the word 'system' in quotes like that. Is it because you don't believe I really have a system, because you don't think it's a very good one, or because you don't agree with systematic trading? GAT
Finally read the blog...very interesting....and no, I am definitely a proponent of using a system to trade. However, your system seems really complex to me. Most complex systems can't be programmed and therefore cannot be backtested. From your blog: re: "The volatility on corn is about half what it is on soya." I'd like to see the study that allowed you to come to this conclusion. What was the time-period ? How many months...years ? Front-month contract only ?
Hi I agree with your statement about complexity; I am not a huge fan of it. My system might look complex, but it's really just a linear weighting of a lot of really simple things. It's fully automated, and backtested. I can point you to the backtest on the blog page if you like. The vol estimate was done taking an average over the 12 months April 2014 to 15, the average over that period of a 35 day exponentially weighted moving average of daily returns. I don't use a very short period because I don't want to keep fiddling with my system's trading speed whenever vol and hence costs move a little bit. Once a year is fine. I'm currently trading 2015 November Soya, and December Corn. I would need to check to be precise, but I probably started trading them in October 2014; before that I would have been on the 2014 versions of those. GAT
Indeed...this Bloomberg report indicates soybeans 3x as volatile as corn: Interestingly this was all about the commodity index at 13 YEAR lows !!!
I think that report is percentage volatility. I'm comparing the bid/ask spread in price terms to the volatility in price terms. Corn is about 1/3 (ish) the price of soya; so if corn had 3 times the % volatility it would still only have the same price volatility as corn. They're probably looking at a different time period as well of course. GAT
re: "bid/ask spread in price terms to the volatility in price terms" That can only be done effectively with intraday snapshots. What is your measurement frequency ? Hourly ? 15 minutes ? re: "if corn had 3 times the % volatility it would still only have the same price volatility as corn" I believe you meant "if Soybeans had 3 times..." You might be right on this, but I think you are using the wrong volatility measure....if in fact, it is an intraday-based value. You're average time-in-trade is probably in days, so it doesn't make sense to use anything but stats using DAILY bars. Bloomberg's volatility is expressed in Annual % of price volatility, but CALCULATED using something the last 30 days using the closing price for the day. You should be using a vol measure based on daily price movement IMHO.