How to research and verify trading ideas

mindtrade · Dec 14, 2009

Quote from love2puck14:

Talon,
I have been following this thread for quite some time and have wanted to chime in but haven't had the courage. But this thread is why I have spent too many hours on this site. That aside I wanted to share a trade idea I had a made some money on. You addressed this earlier and I believe I understand the 2x/3x etf's. To keep it simple, I shorted equal dollar amounts of FAS and FAZ and rebalanced after a 5 to 10% move in either direction. (I would either short more or buy back).

As you said, these etf's will approach 0. I realized this early on. Would you mind elaborating a bit more on why this startegy can't work in the long run? My thought was that in a strong bull market (like we've seen) you will lose money and thus why I stopped. (I felt like I was constantly chasing the big market moves). I'm not sure if I'm making sense here but I think you get my drift.

Thanks for doing this
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I think the main thing against that trade is the cost of carry and the possibility of the shares that you are short being called back.

Mike805 · Dec 14, 2009

Hi Talon,

I've been following this thread and as I mentioned before, I appreciate your efforts. Thanks for your time here, its great to see some real analysis on this site - real content has been lacking on this site for a few years now as I'm sure you are aware.

At this point, should you be so inclined, I'd be especially interested in your pairs system testing/modeling process. By no means should you give away the farm, but if its reasonable, I'd like to know how you qualify/model the "tradeability" of a pairs system, specifically in terms of costs (intraday only) both fixed and dynamic (i.e. slippage and liquidity).

Suppose one were to develop a custom testing enviroment for the pairs appraoch, what would one want to pay specific attention to?

My own pursuits down the pairs road have been somewhat limited as I don't believe I have the infrastructure to make it worthwhile. I'd be curious to hear how you believe one can overcome some of the hurdles.

Thanks,
Mike

bwolinsky · Dec 15, 2009

Quote from talontrading:

I believe there are more intelligent, interested people in this thread than the BoWo trading thread... in fact I find the environment here to be significantly different than it was several years ago. There do seem to be more people here who realize that trading is very difficult and a long, hard road to possible (uncertain) success. Several years ago I remember these boards having a lot of people with a real sense of entitlement ("You owe it to me to share your super secret trading method.") That seems to be gone and I'm encouraged by the level of interaction we've had here... so let's go on a bit.

I did post some on BoWo's thread. To summarize, he has a system built on the ratio of QID / QLD. Now, the irony is the kid doesn't understand basic math, but there really is a possible trade with the leveraged instruments that involves basically being short because the rebalance eventually drives them toward zero. (see FAZ.) This is a trade idea we looked at, but basically decided there wasn't enough juice in it to justify deploying capital there.

Here is part of a post I made in that forum trying to explain the flaws in his system idea. The kid couldn't understand it, but there are some ideas that are interesting for this thread perhaps:

=======================

I made the claim that the QID QLD "Pairs" approach is profoundly flawed. Rather than leaving that hanging where it might look like a mean-spirited attack, let me explain what I mean.

I also haven't taken the time to wade through the OP's self serving drivel to really carefully understand the system. Let me say what I understand it to be, and why that approach is doomed... perhaps I am mistaken in my assumptions (which would be my fault for not reading carefully enough).. then my conclusions would also be wrong.

I believe this is not pairs trading at all because it only trades one leg of QID QLD when he believes the market is overbought / oversold. Thus, there is no ratio relationship or reduction of market risk like one would normally expect from pairs trading. It is a simple overbought / oversold system using leveraged products.

And therein lies the problem. These leveraged products are designed to reflect X times the 1 day return of the underlying. Without going into a math lesson, this means they "reset" each night because they are rebalanced. Tomorrow's QLD is a significantly different instrument than todays! Any analyses based on levels, averages, etc are not valid from day to day on these products because you are comparing apples to oranges. It is possible to construct a mathematical simulation showing how these double and triple leveraged products seem to flex, but it is illusion and does not offer profitable trading opportunities. It would be easy for someone using primitive retail system development tools (Tradestation, wealth lab, etc) to be deceived if they really don't understand the mechanics at work here. I believe this is what happened to the OP due to lack of experience, which is certainly in itself nothing to be ashamed of. We all started with no experience but I find people who are successful in this business maintain a pretty consistent air of humility that is quite at odds with BoWo's chest thumping.

The OP should also check out the settlement prices he is using since these products do not settle like regular stocks and that procedure has changed and evolved as they became more popular. In other words, he is unlikely to be able to execute at his backtested prices because the lookback data won't carry forward. We could also discuss the logic of presenting levels for a stock to the 10th decimal place, but that's just a matter of experience.

I could go on, but I know some people are reading this thread and wanted to offer them a bigger picture perspective on the "system" that is being discussed. The rebalance issue seems like a simple one, but it is at the very core of the concept... and sadly, that concept is profoundly flawed.

Shame the OP will never read this since he has me on ignore, but I'm offering this as a public service message... it's not for him any more than last night's stats lesson was for him... if someone else reading this can carry a lesson away then my time was well spent.

You are correct, the idea in a pairs trade is to sell something overvalued and buy something undervalued. You are also correct there is usually, but not always, the expectation that some directional market risk will be eliminated from the process of buying / selling. You are completely wrong and show your inexperience in saying that daily pairs trading is more efficient than intraday. I realize this is a limitation of your testing environment and lack of access to real data (bid/ask spreads historical lookback). The central idea with pairs trading is that instruments "should" (or do) trade in a normal relationship, however you define that. Departures from that normal relationship are trading opportunities for pairs models. These departures happen more often and with more predictability intraday. There are more trading opportunities and your risk is better controlled. It is very true that execution (which is a learned skill) plays a big part of intraday pairs trading and that costs will represent a much larger percentage of your P&L, but that is true of any intraday trading. If you do decide to investigate these intraday models I will caution you that you must work off bid / ask spreads. There are many intraday pairs that might look profitable to you using WealthLab, but the spread completely accounts for the total potential profit in the trade (thus, no trade.)

Now, here's where you need to pay attention because here's why your QID / QLD system will not work. You may use the f-word at me now, you may pretend you didn't read this, but 2 or 3 years down the road come back and re-read this. Ready?
-In a pairs system we look at the ratio between two securities. We find some kind of normal value and recognize trading opportunities when there are departures from that normal value.
-Your system uses double and double inverse QQQQ's. These instruments do a pretty good job (very small tracking error (look it up, probably in that stack of CFA books you should have studied...) of doing what they are designed to do which is to replicate twice and twice the inverse one day percentage return of the underlying.
-Thus, the ratio relationship is completely deterministic. Simple math (I'm not going to do it for you here) will show you that this ratio will flex according to the size and direction of the moves of the underlying. There is no rubber band... there is no flexing around value. You can build a simulation in Matlab (or Excel if it's all you've got) and see how this works... and then verify that the QID QLD spread behaves as the simulation would predict.
-Any optimization is basically asking the question: "Over the last two years what size pullbacks should I have been buying and selling in the Q's." You will get a good answer that will make your system results look great, but it is a function of the natural math of this flexing. You do not understand this. The parameters you optimize will have absolutely no carry forward because there is no actual pairs relationship.

How do I know this? I have never thought of this as a trading idea until last winter when a smart kid interviewing for a summer internship brought an idea very similar to your QID / QLD pairs system to us. (Wolinksy... you weren't the first to think of this lol.) in talking through it in the interview, I was able to lead the kid to see the error in his thinking in 3 or 4 minutes... like I said he was a smart kid. Afterward, I found the idea intriguing enough that we did a little simulation and testing to verify no trade.

It is easy to be fooled by relationships like this, especially when you don't have a lot of experience with these models and actual trading. I'm not criticizing you for making this mistake, but open your mind and consider carefully what I'm saying here. If you have questions, please ask... I will do my best to help you understand and to answer any questions.

I'm certainly not an expert at pairs trading. yes I have some pairs models that make pretty consistent money, but it's not what I would consider a passion or an area of expertise. Still, this is pretty simple.
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Again, blabbing on, without attempting to understand. You are no expert at pairs trading, and I get that by the lack of profitability in your pairs distribution.

xburbx · Dec 15, 2009

i thought the trash talking and bitching was done with on this thread?

bwolinsky · Dec 15, 2009

Quote from xburbx:

i thought the trash talking and bitching was done with on this thread?
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I am not talking trash, they are. I've made my point. I think he's more upset about this thread being centered around a "Lucky system" with a WL Luck Coefficient of 103. Anything below 10 is not, and it is actually one of their trainee's that did not have that problem, nor with the pairs model. It's a real good thing he surrounds himself with modellers. He'd be lost without them.

bwolinsky · Dec 15, 2009

Quote from Mike805:

Hi Talon,

I've been following this thread and as I mentioned before, I appreciate your efforts. Thanks for your time here, its great to see some real analysis on this site - real content has been lacking on this site for a few years now as I'm sure you are aware.

At this point, should you be so inclined, I'd be especially interested in your pairs system testing/modeling process. By no means should you give away the farm, but if its reasonable, I'd like to know how you qualify/model the "tradeability" of a pairs system, specifically in terms of costs (intraday only) both fixed and dynamic (i.e. slippage and liquidity).

Suppose one were to develop a custom testing enviroment for the pairs appraoch, what would one want to pay specific attention to?

My own pursuits down the pairs road have been somewhat limited as I don't believe I have the infrastructure to make it worthwhile. I'd be curious to hear how you believe one can overcome some of the hurdles.

Thanks,
Mike
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If you have WLP, you already can do this. It is available on wealth-lab.com. If you don't you should still visit the site, and pluck the model from there. It's all you need. You programmers always feel you need to re-invent the wheel, when all you have to do is add, subtract, multiply, and divide.

Mike805 · Dec 16, 2009

Quote from bwolinsky:

If you have WLP, you already can do this. It is available on wealth-lab.com. If you don't you should still visit the site, and pluck the model from there. It's all you need. You programmers always feel you need to re-invent the wheel, when all you have to do is add, subtract, multiply, and divide.
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LOL..

Beau, when you figure out how to model a bid/ask spread or non time-based data in wealth-lab, or with any other software for that matter then let us know... maybe by then you'll have some humilty.

You are likely not aware of the fact that intraday pairs systems have to account for the bid/ask spread. Good luck getting the close of bar with decent size.... You know that most retail software packages will not allow one to simulate that level of granularity, right?

I am curious if doing the work to properly test this trade is even worthwhile, hence my earlier question.

And yes, I know you only use daily bars... good for you, now move along.

Mike

talontrading · Dec 16, 2009

Just ignore him here and don't respond to any of his posts. He's confused and a little dim so don't let him derail this thread again.

The risk management topic is a good one. Will get to it soon... kinda slammed by end of year stuff... as I said I'm encouraged by the response to this thread so we will definitely continue.

One last comment about BoWo... the people I work with read early posts I made (I find it very useful to bounce everything off of other people... that's a big reason for not working alone). The consensus was that I was an idiot because BoWo was clearly a joke -- meaning that he wasn't a real poster and didn't expect to be taken seriously.. who could seriously say they are the best system developer ever? Well... the joke is on them because apparently the little fatso really takes himself that seriously.

So now he's going to cry and freak out on this thread... but just ignore him.

Quote from bwolinsky:

I am not talking trash, they are. I've made my point. I think he's more upset about this thread being centered around a "Lucky system" with a WL Luck Coefficient of 103. Anything below 10 is not, and it is actually one of their trainee's that did not have that problem, nor with the pairs model. It's a real good thing he surrounds himself with modellers. He'd be lost without them.

talontrading · Dec 16, 2009

You know, the moderating for these threads, specifically wrt BoWo, leaves a lot to be desired. There is a clear pattern here:

1. BoWo behaves for a while.
2. He freaks out and makes a ton of posts... some really inappropriate.
3. People respond.
4. The moderator deletes only BoWo's freakout posts and the posts responding to that, leaving him looking like a much more rational person than he is so people who come to the thread tomorrow don't really see what is going on.
4a. The moderator goes through BoWo's posts and removes the F-word, again making him appear more rational than he is.

This is not ok... either block the guy from the thread or leave it alone. This middle ground is not good because the end effect is the moderator (Magna?) is basically protecting BWolinsky. I believe this is being done with the idea of respecting the integrity of the thread, but it really has to be an all or nothing deal.

Mike805 · Dec 16, 2009

Quote from talontrading:

You know, the moderating for these threads, specifically wrt BoWo, leaves a lot to be desired. There is a clear pattern here:

1. BoWo behaves for a while.
2. He freaks out and makes a ton of posts... some really inappropriate.
3. People respond.
4. The moderator deletes only BoWo's freakout posts and the posts responding to that, leaving him looking like a much more rational person than he is so people who come to the thread tomorrow don't really see what is going on.
4a. The moderator goes through BoWo's posts and removes the F-word, again making him appear more rational than he is.

This is not ok... either block the guy from the thread or leave it alone. This middle ground is not good because the end effect is the moderator (Magna?) is basically protecting BWolinsky. I believe this is being done with the idea of respecting the integrity of the thread, but it really has to be an all or nothing deal.
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You're forgetting that Bowo's M.O. is: "any attention is good attention".

If there is one thing that Bowo is the best at, its getting negative attention. Quite impressive actually...