The Machine Monthly Newsletter – April 2011
FROM THE DESK OF LARRY CONNORS
Welcome to this month’s edition of The Machine Newsletter.
Over the past month we’ve added a number of new features to The Machine to help improve your trading. We’ve added the new ETF Limit Strategy which has the highest test results of any ETF method we’ve created. We’ve also added a new equity short strategy named “Short Surge” to allow you to find additional opportunities in overbought stocks.
This past week Chairman’s Club members received access to our new risk management tools including a Risk Metrics Histogram, along with Dynamic Hedging to help hedge portfolios from large market moves. These risk management tools will be expanded to Pro subscribers into The Machine later this month.
Finally, automation is getting closer. BNY/ConvergEx, who is overseeing the automation, has partnered with the first brokerage firm (TradeStation). The automation is now in the beta phase and I expect them to be bringing more brokers to the platform as time passes. I’ll have more details on this for you next month.
Thank you again for subscribing to The Machine. And thank you for the many suggestions you have sent us. Many of the new features and improvements came from you and it’s greatly appreciated by us.
I hope you enjoy and learn from this month’s issue of The Machine Newsletter.
Larry Connors is CEO and co-founder of The Connors Group and TradingMarkets.com
USING THE MACHINE AS AN INVESTMENT ADVISOR
In this article for The Machine Monthly Newsletter, I would like to focus on controlling duplication of symbols in portfolio building. I use a Machine portfolio I call AMP, for “All Markets Portfolio”, in my advisory business. Please visit my website at www.kayinvestments.com and contact me to discuss investment ideas.
One of the goals of investment management is to create uncorrelated, or low correlated streams of investment returns. The benefits of this diversification include smoother returns and lower drawdowns. The Machine serves this goal by providing different types of strategies, i.e. long and short, mean reversion, trend following, day trading, equity and ETF.
One thing we never want to happen, of course, is to find that somehow we wind up holding a high percentage of our portfolio in one stock or ETF. I have learned through experience that certain precautions do need to be taken to build a lower risk, lower drawdown portfolio.
The Machine offers 11 different equity long mean reversion strategies and 9 different ETF long mean reversion strategies. More are on the way. Your first thought might be that these strategies diversify each other, i.e. that you could combine many (or even all 20!) of these. Unfortunately, symbols will overlap and you would need to be prepared for the possibility that they all fill on the same day.
Here is the approach I take to control the problem:
- I have made a decision that I don’t want more than 2.5% in any one symbol. In the rare event that an ETF symbol overlaps a stock symbol, or mean reversion overlaps trend following, I may allow a little more than 3%.
- I use only 10 position mean reversion strategies in order to allow more different symbols. I prefer the 20 position equity and 15 position ETF trend following to provide more symbols and so that it matters less when they occasionally overlap.
- I have selected several mean reversion strategies, each featuring 2.5% per position, but I have a set priority order in implementing them. I will not place orders on more than one symbol at a time, in those cases when the strategies overlap.
- I intentionally create as much contrast as possible among the strategies. For example one strategy will use 2.5 million average share volume and another will use 1.0 million.
- As mentioned in my last newsletter, I will always use trend following, partly because this also reduces overlap: trending symbols tend not to be mean reversion symbols.
- I am studying the recently implemented ETF day trading with an eye toward minimizing overlap. I will favor the higher max position strategies for this reason.
I am a big believer in the philosophy “see the trade, take the trade”. Nevertheless, I will intervene in a systematic, pre-planned way in order to avoid symbol overlap.
HOW BUILD A RANDOM PORTFOLIO
The Machine contains 46 Strategies and over 43,500 different variations of those strategies. With strategies ranging from mean reversion to Trend Following, I am often asked, “Which strategy do I choose?”
The answer is that as long as you build a balanced portfolio, you can choose any of them.
Balance is achieved by diversifying your portfolio with the various strategy groups that are within The Machine, not by balancing between different asset classes such as stocks, bonds and cash.
Including long and short strategies allows you to profit when the markets move up as well as when they move down. The time frame that you trade is another great way to diversify. You can include strategies that trade short term or mean reversion as well as the longer term strategies such as trend following. And you can further diversify by using a blend of Stock and ETF strategies.
You will find that as you achieve balance in your portfolio, your volatility and often times your drawdown is going to be lower, and your returns are going to be much smoother and more consistent over the long term.
Now the question is which strategy to choose for your portfolio. In previous articles I spoke about using the strategy selector to help narrow down the strategies by looking for specific metrics that you are looking to achieve. The strategy selector enables us to look for specific CAGR, Drawdown, Sharpe Ratios and a number of other criteria. Position sizing menus and volume diversification can all be implemented to ensure further balance.
Today we are going to build a balanced portfolio by selecting the 20th highest CAGR for each strategy group that we include in the portfolio. This will be a good exercise to show just how robust The Machine is and to show how many different variations can be used for a portfolio.
First we are going to set some specific criteria for the strategy variations by using the Strategy Selector. We will look to add strategies that have a maximum drawdown of no more than -25%. We will then select the 20th highest CAGR on the list for each strategy group and build our portfolio.
We performed this search for each of the strategy groups within The Machine. Further position sizing and volume requirements were included to ensure optimal diversification. Below are the results:
This portfolio is very unique in the fact that it contains variations that are the 20th Highest CAGR in each category group. This also shows the power of building a balanced portfolio of different strategies. By randomly selecting the 20th highest CAGR in each strategy group we were able to build a portfolio that had double digit annual returns in every year, and a maximum drawdown in the single digits. Of course you can likely do even better by using your own strategy selection criteria.
Phil Suarez is Director of Education for The Connors Group
TRADING WITH “THE COURAGE OF YOUR CONVICTIONS”
“The market does not beat them. They beat themselves, because though they have brains they cannot sit tight… He had not only the courage of his convictions but also the intelligence and patience to sit tight.”
But what if this time is different? The trader’s fear. You believe in your system, but what if this is the start of a “Black Swan” event?
Too many times traders succumb to the fear and quit trading at exactly the wrong time.
It has happened to many good traders already in 2011. The revolution in Egypt. Civil War in Libya. The earthquake in Japan and a terrible tsunami. Then the nuclear disaster.
In each case the market crashed. Most likely your account was down and you were getting long signals on your trading system (most Machine strategies were giving long signals).
The SPY was down -6% over the period of the Japan disaster. Over the next 10 days the SPY gained greater than 5%. Many of the strategies in The Machine did much better than that.
Did you take the trades? Or did you quit trading and miss the subsequent upside bounce?
“Fear keeps you from making as much money as you ought to.”
It is always hard to “see the trade, take the trade” during these periods. The Machine shows you the historical simulated performance of your portfolio for every calendar month and year since 2001. This certainly helps give you the confidence to “see the trade, take the trade.”
And now The Machine can help you to have even more courage in your convictions.
The new Returns Distribution Histogram allows users of The Machine to see exactly what the simulated historical returns look like for their portfolios over various periods of time. Below you can see a histogram for a sample portfolio.
This histogram shows the returns for every 10 day period for this portfolio going back to 2001. The shaded areas represent the approximate +/-1 sigma, 2 sigma, and 3 sigma distributions. The header of the chart tells us that the average 10 day return is +1.03%. More importantly, the chart shows that approximately 95% (2 sigma) of the returns are above -2% and 99% (3 sigma) of the 10-day returns are above -3.5%.
This information tells the trader that if you are experiencing a period where your portfolio has lost -1% or even -2% over 10 days, that the period you are experiencing is well within the historical norm. This gives traders the confidence to trade through tough periods like we had in February and March.
And, if a true Black Swan event does occur you will have a signal to take actions for your portfolio to protect your capital. For instance, if someone trading this portfolio experienced a -8% return over a10-day period, they might want to go partially or completely to cash as a defensive move. A return of -8% would be completely outside all historical data for this portfolio.
Traders can also look at other time periods. The Machine gives you the ability to look at histograms for returns over periods of 1 day through 10 days, 15 days, 1 month, 2 month, 3 month, 6 month, and one year. These are rolling periods of trading days. Since a year represents 252 trading days, the histogram looks at every 252 day period since 2001 when calculating the returns distribution for 1-year.
The Machine Returns page gives useful information regarding the year-by-year and month-by-month returns, but the histogram takes it to a completely different level.
Looking at the 1-year histogram gives traders insight as to how they can expect their portfolio to perform over longer periods of time. This sample portfolio has had better than 20% annual returns every year. But the information on the 1-year histogram is even more impressive. The portfolio’s worst 252-day period was +12.53% and its best 1-year period was +55.75%.
Trading can be challenging at times when the world seems to be going crazy. This kind of information gives traders the confidence to weather the inevitable storms.
WHAT’S NEW IN THE MACHINE
- Dynamic Hedging was introduced to The Machine on March 31st. Dynamic Hedging is a risk management technique that can be used to reduce the inherent risk associated with holding stock and ETF positions overnight.
- Short Surge is the first new short-term short-only equity strategy in almost a year. It has 1,080 variations and was released on March 30th.
- 11 unique Performance Money Back Guarantee Portfolios have been available since March 8th.
- ETF Limit 1 is the first short-term long-only ETF strategy that utilizes limit orders in The Machine. It also includes a new US ETF Universe. It was released on March 4th.
- March 2011 numbers will be available on April 15th.