Wednesday, December 07, 2005

What Should I Trade?

On the Performance page of my site, I emphasize that trading performance is a function not only of how you trade, but what you trade. When TraderFeed reader Paulo de León pointed out that the NASDAQ averages were losing volatility relative to the rest of the market, it drove home the point that what constitutes the best thing to trade changes over time. I will have an article on the Trading Markets site later this week on the topic.

Here's a dramatic example. Since January, 2000, the S&P 500 Index is down about 13%. The NASDAQ 100 Index is down 55%. In that same period, however, the Russell 2000 average is up 38% and the S&P Midcap Index is up about 69%.

Moreover, volatility of the Russell stocks has been increasing relative to the S&P--unlike what we're seeing in the NASDAQ average. Volume in the MDY exchange traded fund (for midcap issues) has expanded several-fold since 2000. Yet we continue to see far more traders banging their heads against the S&P 500 and NASDAQ 100.

As this blog evolves, I will use it increasingly to identify what to trade, not just when to do it. It is not clear to me from the research I reviewed on my site that the big name stocks are necessarily the best trading--or investment--vehicles.

4 comments:

Greg Lepiaf said...

Hi Brett !
First of all Thank You for everything you give on your various web pages.
A comment (in fact a question) adressed to your post and to Paolo.
There are indeed changes in the behavior of the markets. Many trading strategies I have studied have completey changed their results about one year ago. Are these changes long term or short term changes ?
One plausible explanation for them relies on the massive intrusion in the last years of the hedge funds. I consider here only those hedge funds which play short term trading - arbitrage, momentum, etc - and are highly computerized. These hedge funds are moving much more money these days since they have received a great money inflow in the last years.
I believe their massive computerized activity may be responsible (in part) for the lower volatility : very rapid transactions and very rapid profit taking should limit, at least for now, the excursions from a "fair price".
I have no direct evidence of this hypothesis, only indirect observations. Has anyone elements to confirm or infirm it ?
Since the impact of hedge funds could be important on our trading, it would be nice to have some tracking of it : for example, various data separate trades from "individuals" from trades by "institutionals". Is there any comparative data about the trading of these hedge funds ?
In fact if my hypothesis turns out to be right, we may have to integrate the hedge funds behavior in our own analysis and strategies.

Greg Lepiaf said...

Hi Brett !
First of all Thank You for everything you give on your various web pages.
A comment (in fact a question) adressed to your post and to Paolo.
There are indeed changes in the behavior of the markets. Many trading strategies I have studied have completey changed their results about one year ago. Are these changes long term or short term changes ?
One plausible explanation for them relies on the massive intrusion in the last years of the hedge funds. I consider here only those hedge funds which play short term trading - arbitrage, momentum, etc - and are highly computerized. These hedge funds are moving much more money these days since they have received a great money inflow in the last years. I believe their massive computerized activity may be responsible (in part) for the lower volatility : very rapid transactions, very rapid profit taking, should limit, at least for now, the excursions from a "fair price".
I have no direct evidence of this hypothesis, only indirect observations. Has anyone elements to confirm or infirm it ?
Since the impact of hedge funds could be important on our trading, it would be nice to have some tracking of it : for example, various data separate trades from "individuals" from trades by "institutionals". Is there any comparative data about the trading of these hedge funds ?
In fact if my hypothesis turns out to be right, we may have to integrate the hedge funds behavior in our own analysis and strategies.

Paulo de León said...

Hi Greg
Tx for following up on the subject. You went one step ahead and try to give it a shot in the reasons for this loss in volatility in these markets. I agree with you in several things. Many of my strategies were damaged this year due to this low volatility. When low volatility appears two things happened in the strategies: a) payout ratio decrease (even less that 1) b) the winning ratio also decrease.
As traders, the convetional wisdom´s response to the decay in volatility is to increase the Number of lots, however that rule would be catastrophic in a year like this. I realized early in the year that when the payout is damaged you should cut your bet size, that is low volatility in intraday trading equals less agresivity in lot size. Or maybe, as Brett is stating change the market traded.
Possible explanations to this problem: one is the hedge funds and their program trading; but i wonder if the fundamentals validate this phenomenon or the phenomenon validate the fundamentals. As the economic indicators and corporate news are erratic and choppy.
I´m a big fan of Victor Niederhoffer and the principle of ever changing cycles. As this phenomenon is soo obvious maybe is about to change. I studied long term ranges in the dow jones from 1920 to date.
Using monthly closes i calculate the 18 mth range, high close over lower close. Right now we have an 8.4% range, the lowest in a century. The study also show that the market contract and expand in cycles during aprox. 4-5 years on average from bottom to bottom. This current low is the worst only matched with the 1993-1994 (9.6%) and the 1948 (8.8%) lows.
I sincerely aprecciate the work of Brett that allow us to express ourselfs and share his knowlege just for the passion about trading.

Brett Steenbarger, Ph.D. said...

Greg and Paulo,

You make great observations. My only question is whether it is truly hedge funds that are helping to reduce the volatility. Rather, the high degree of computerization among the "local" firms that dominate short-term trade in the electronic stock index markets has created large size in the order book and a much less fluid movement of the futures contracts. To the degree that *who* is in the market changes over time (as well as *how* they trade), we can expect patterns in markets to appear and disappear. This means that we not only have to analyze markets to find patterns, but periodically reanalyze them. Thanks!

Brett