Quantitative Trading

Buying and selling stocks and derivatives have increased
enormously over the last decade. An occupation, earlier restricted
to a few well-situated capital owners, has now become almost a
national movement, involving a majority of the Swedes. There are
reports estimating 80% of the Swedes, 16 years of age and above,
to be shareholders, directly in the markets or indirectly by pension
funds (Modig, 2001).
The stock market is a popular subject of discussion at work, at
home, and in the tabloids. Media are reporting of people gaining
huge amounts in the markets, but also giving hindsight descriptions
of how one could have made millions, or more recently, how much
capital that was lost in the latest decline. During the last quarter of
1999 and first quarter of 2000, when stock market indices around
the Western world soared to new highs, there seemed to be one
question on everyone’s mind; what stock should I buy to get the
best profit? However, since March 2000, during the decline, the
focus has somewhat changed to how one should avoid getting
ruined. Why do some people succeed in the markets, while others
are going bankrupt? Some possible clues can be found when
reviewing the psychological research that has been made within
the domain of behavioral finance.
When participants of the markets are studied in real life, they seem
to present a number of shortcomings, one of them can be
characterized as overconfidence (Scott, Stumpp & Xu, 1999).
Camerer and Lovallo (1999) found that overconfidence presented
by business managers leads to excessive business entry. When the
results were based on the participants’ abilities, individuals tended
to overestimate their relative success and enter more frequently.
This was not because of irrational information processing or
neglecting the competition they were up against. They were just
overconfident about their relative skill. Studies made by Kahneman
and Tversky (1973) show that humans have a tendency to
overestimate the probability of one’s forecasts. Among other
reasons, such as a prolonged bull-market, huge financial resources
and numerous media reports of rising markets and big gains, an
overconfidence effect could be a contributing factor to the great
number of “new” and inexperienced investors entering the stock
and derivatives markets.
Investors adjust their expectations slowly (Daniel, Hirshleifer, &
Subrahmanyam, 1998), and as a possible effect, they did not see
when the bull-market turned into a bear-market, leading to holding
on to their positions longer then expected.
Further, when we as humans make decisions under uncertainty,
our choices are influenced by the way we describe, “frame”, the
situation rather than the absolute value of the result. When we
perceive the situation as a loosing scenario, a negative framing, we
tend to be risk seeking. Consequently, if a scenario is perceived as
positive we will become risk-averse (Kahneman & Tversky, 1979).
This could have caused investors to take greater risks during the
big decline than they otherwise would judge as reasonable.
Altogether, these human foibles make investing or trading in the
stock markets a difficult task. How could one possibly become a
successful market player?
One of the recipes of success, at least according to non-academic
literature, is to control one’s risk and utilize proper “money
management”. The definition of money management is not
perfectly clear and according to trading coach Van K. Tharp, it is
not “risk control” per se, “diversification” or “how one makes
trading decisions” as sometimes stated (Tharp, 1998). Risk control
and maximization of profits is rather a result of implementing
money management strategies. Tharp emphasizes that money
management or position-sizing (this term will be used in the
following) answers the question: “How much?” or “How many?”
(Tharp, 1997). In the meaning of “how much of available capital is
to be put at risk?” or “how many contracts or shares are to be
bought?” In this paper the following definition of money
management will be used: Money management determines how
much of available capital is to be allocated in a specific market
position, that is, the number of shares bought or percentage of
total capital spent.
Author/trader Jack Schwager has published two bestsellers, Market
Wizards (1993) and New Market Wizards (1994) where
approximately forty exceptionally successful traders were
interviewed. These traders were chosen on the basis of
consistently high annual return or extraordinary growth:
I was looking for people who had attained “incredible”
achievements in the market, such as a 12-yr average
annual return of 45% with only a 5% max draw-down
(Gil Blake), or turning $30,000 into $80 million
(Marcus) etc. The methodologies used was[sic] NOT a
precondition but rather an information item I sought
out. (Schwager, 2000).
There was not one particular method of analyzing the markets, nor
one sole buy-sell strategy that could account for how these traders
could be so prosperous. However, one common trait in their
approach towards the markets was their ability to manage risk.
Earlier during their careers some of them had, completely or
almost, lost their trading capital. The one thing separating these
future “market wizards” from other losers was their ability to learn
from their mistakes by analyzing the risks they had taken, to
develop and launch strategies for never letting themselves get
stuck in the loss-trap again.


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