Trading Signals

A trading signal is a mechanism or trigger that is driven by a a strategy in an effort to generate returns from specific securities. A signal can be anything from an event, that changes market participants view of a securities value, to price action, which reflect the supply and demand for a security within the marketplace.

Trading signal are generally designed to meet a specific risk reward criteria that a portfolio manager is looking to achieve. There are two distinct types of trading signals employed by traders in the capital markets. The first is a automated strategies and the second is a discretionary strategies.

Automated Strategies

Automated strategies are generally strategies that have been back tested using historical data. Specific criteria of price action are used to determine if the market mechanism or price action event can foretell future price action. Back testing data is generally driven by using computer programs, that can determine if historical patterns can be profitable based on a risk reward profile.

Designing automated trading strategies start with determining the type of trading strategy the portfolio manager is interested in trading. Many traders feel comfortable trading trends, while other enjoy trading dips and peaks. A trend following trading strategy is one in which a trader looks to follow moving averages or momentum. Two such examples are moving average crossover strategies momentum crossover strategies.

Trend following

A moving average crossover strategy is one in which a trader looks for a short or medium term moving average to cross either above or below a longer term moving average. For example, a trader might look to purchase a security when the 20-day moving average crosses above the 50-day moving average of the security. The reverse would be true for a downward trend. A trader would look to sell a security when the 20-day moving average crosses below the 50-day moving average.

A momentum trading strategy could use a MACD (moving average convergence/divergence index). In this strategy, the difference (the spread) between moving averages (the 12-day moving average and the 26-day moving average) are compared to the 9-day moving average of the spread.

Mean Reversion

Another type of automated strategy is the mean reversion strategy. This type of trading strategy tries to measure how far a security or pair of securities can move from a long term moving average before it bounces back. Many mean reversion strategies use concepts similar to the Bollinger bands which measures an “x” standard deviation from a mean to measure when the proverbial rubber band will snap back.

Discretionary Strategies

Discretionary strategies are concepts that have worked in the past for a trader but do not follow specific iron clad rules to determine when a trading signal is triggered. Discretionary traders will use specific events, including economic data, earnings data, monetary data or political data, along with or without specific types of technical analysis to generate a trading signal.

An example of a event would be an employment report for a specific country or a monetary policy meeting in which new information is release that is current not priced into the market for a specific security.

Discretionary strategies can also employ support and resistance levels that are breached based on subjective trend line variations. Support and resistance levels usually designate price demand and supply, and when breached give way to momentum in the direction of the break out.

Risk Reward

With both automated and discretionary trading signals, the risk that is generated needs to be compensated by the reward received. Back tested results need to show profits based on criteria that do not create the risk of ruin.

Prior to finding a trading signal, a trader should look at the historical track record to determine if the risk taken by the strategy is outweighed by the reward generated by the strategy.

Acsye – Week 9 2012

Considering market micro-structure for the propriety trader or hedge fund is a first step to understanding the relationship between cost and risk. Risk can be described as the probability of losing money or the probability of making money. Often the last part of this true definition of risk is neglected.

The more you risk, the more you Make.

The Noble Foundation awarded a prize for Economics[1] in 1990 to Merton Miller for his work on this premiss[2]. For a proprietary trader or hedge fund, risk is good and needs to be harnessed.  We are risk managers in many aspects of Life, money making and economics is a huge part of our daily life. Like Sport, Love, Adventure, Education, all of these carry risk. Before discussing Strategy Details and Microstructure it is important, I think to grasp the idea that ‘Risk is Good’  and should be welcomed by the investor or trader rather than extinguished; this fire just needs to burn

Fig.1 shows the current allocation for my personal account. This portfolio has considerable risk.  Specifically it is exposed to the US Dollar and Swiss Franc. A few months ago I had a similar exposure only to find that the Swiss Central bank announced that they would de-value the Franc as necessary to maintain economic stability in Switzerland[3]. I lost 700 bps on the day on the account, due to the rantings of a politician. I did not understand the ‘detail’ of the risks of my strategy and now several months later I am still unsure. How do you trade around macro economic shocks caused by political statements? A common recent strategy is to close all positions frequently to avoid shocks, this leads to high, prohibitive trading costs; whilst diversification and balancing of a broader portfolio is cheaper and works well

A broader long-term, balanced portfolio unfortunately reduces risk over the long term, unless we are blessed with a macro economic shock

Any exposures can be haunting after a macro-economic shocks and the detail of a strategy should address these potential shocks, market micro-structure represents the other end of the scale and is concerned with the cost of regularly trading the detail of a strategy. Specifically and in economic terms the analysis of micro-structure and the algorithms designed to manage risk are looking at the Transaction Cost Analysis of the strategy, TCA. Ultra High Frequency  strategies will incur higher hedging costs and higher executions costs; but these UHF strategies will incur considerably lower risk than a longer term strategy, due to them leaving the market ahead of any macro shock or drift away from profitability.  The detail of a strategy can paradoxically reduce risk via long term or short term trading (see diagram from last blog) but costs go up with trade frequency

High frequency trading strategies have now created a rod for their own back as they hammer and reduce risk, they destroy the life-blood that should feed them and incur ultra high transactions costs.

Introducing a reduced cost model and increased risk model, whilst entertaining strong risk management is the next step.

This leads me to my conclusion that Risk and hedging Costs are inversely proportional to each other. For for my most profitable strategies costs are low and risk is high, because Risk is Good

Until next Week 10

Acsye™

Next week: Your Money and Transaction Costs

In accordance with the NFA’s February 2012 Rule 2-40 amendments, managed forex accounts providers or associates are required to obtain certain financial and personal information from their clients. At a minimum, providers and associates must be able to get their customer’s real name, business or principal occupation, address, previous investment, forex trading and futures trading experience. For individual customers, managed forex asset managers and associates are supposed to obtain their net worth or net assets and current average annual income or their previous year’s income.

Based upon this information, managed forex providers and associates are required to decide on the suitable risk disclosure document to provide to their clients.  As a fundamental requirement, managed forex Introducing Brokers and Forex Dealer Members must present to their clients a comprehensible and well-timed written risk disclosure statement touching on vital features and risks of managed forex accounts prior to them opening accounts.

The provided risk disclosure statement must incorporate the approved disclosure language in CFTC Regulation 5.5(b). Additionally, the prescribed risk disclosure statement should be immediately followed by: (1) Total number of non-optional managed forex accounts run by the manager, (2) percentage of managed forex accounts profitable in the quarter and (3) percentage of such accounts not gainful in the quarter.

In the process of determining whether managed forex accounts were profitable or not, asset managers are required to follow the formula set forth by CFTC Rule 5.18(i). The legend “PAST

PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS” should also be included in this section.  It is required that managed forex IBs provide this information on behalf of the FDM to whom they are introducing the account.  Members are also required to obtain a signed and dated acknowledgement from the retail customer indicating that the client received and comprehended the disclosure statement prior to opening account.  Managed forex account managers must update this disclosure before entering into new forex transactions with current clientele if failing to update the information would make it misleading.

It’s upon the managed forex Member or Associate to decide whether additional risk disclosure for a particular customer is appropriate. For instance, if a client doesn’t have any experience trading forex, the Member or their Associate ought to determine what extra information the customer needs in order to make a knowledgeable decision on whether to venture into managed forex account investment.  In some cases, (e.g. if a client is living on social security or seeking safe investment), the Member or Associate may even have go a step further to inform the customer that forex trading is very risky. However, Member is not required to reject the managed forex account if a client, after being given extra disclosure, still insists on managed forex investing.

Managed forex account managers and solicitors, however, are barred from making personalized recommendation for which the asset manager or solicitor ought to or should have notified that forex trading is very volatile for the particular customer.  The NFA states that managed forex Members aren’t required to give their Associates a set of rigid criteria which determines whether or not clients are in need of additional risk disclosure.  A managed forex firm should, however, be capable of articulating the factors its Associates take into account when making the decision on whether to give additional risk disclosure.