15th June 2013: 10 Books For First Trading System

I’ve spent the past three weeks developing my first trading system: a value-influenced mean reversion strategy that includes causal variables for hedge fund activism and political risk. Here are 10 books I used as part of the development process for my first trading system:

 

1. Jeff Madrick’s Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present (Alfred A. Knopf, 2011). Madrick’s overarching history of Wall Street provides detail on central bank, monetary policy, political administration, industry sector, and deal flow variables. It’s also great investigative journalism that gives a deep historical background to what capital and financial markets are really like.

 

2. John Heins & Whitney Tilson’s The Art of Value Investing: How the World’s Best Investors Beat the Market (Hoboken, NJ: John Wiley & Sons, 2013). I started with value investor wisdom for the initial idea development and possible decision rules. Heins & Whitney’s investment newsletter interviews gave me plenty of examples for inductive data coding.

 

3. Anti Ilmanen’s Expected Returns: An Investor’s Guide to Harvesting Market Rewards (Hoboken, NJ: John Wiley & Sons, 2011). Ilmanen was one of the first sources I consulted to understand the historical return drivers of equities as an asset class, and its inter-market relationship with other common asset classes.

 

4. Andrew W. Lo’s Hedge Funds: An Analytic Perspective (rev. ed.) (Princeton, NJ: Princeton University Press, 2011). Hedge fund activism that shapes equities asset prices is a key causal variable for the mean reversion strategy. Lo’s research highlights some hedge fund trading patterns and shows how to draw inferences from databases and market data.

 

5. Keith Fitschen’s Building Reliable Trading Systems: Tradable Strategies That Perform as They Backtest and Meet Your Risk-Reward Goals (Hoboken, NJ: John Wiley & Sons, 2013). I’ve read several books that go back a decade on mechanical, automated and algorithmic trading systems. Fitschen highlights mean reversion and momentum strategies, and the importance of robust backtesting with both in-sample and out-of-sample market data.

 

6. Richard Tortoriello’s Quantitative Strategies for Achieving Alpha (New York: McGraw-Hill, 2009). Tortoriello’s book is essentially a collection of factor models and quantitative screens that uses a Standard & Poor’s rating methodology. Factor models help to isolate the potential alpha of return drivers from the market beta.

 

7. Barry Johnson’s Algorithmic Trading & DMA: An Introduction to Direct Access Trading Strategies (London: 4Myleoma Press, 2010). Johnson covers the importance of market microstructure, early developments in algorithmic and high-frequency trading, and the importance of transaction and execution costs. Several publishers are releasing new books about these topics in the second half of 2013.

 

8. Aaron C. Brown’s Red-Blooded Risk: The Secret History of Wall Street (Hoboken, NJ: John Wiley & Sons, 2012). Brown is a risk manager with AQR Capital Management. One of the many insights I took from this book was the importance of risk ignition in ‘live’ testing of a trading system, and in considering exit signals.

 

9. Ari Kiev’s The Mental Strategies of Top Traders: The Psychological Determinants of Trading Success (Hoboken, NJ: John Wiley & Sons, 2010). The late Ari Kiev was an influential sports performance and trading psychologist who consulted with Steve Cohen’s SAC hedge fund. He has written several best-selling books on trading psychology. This book deals with expectational analysis and variant perception (Michael Steinhardt) which frames the entry signals and filters that a trading system must have.

 

10. John Coates’ The Hour Between Dog And Wolf: Risk-Taking, Gut Feelings, and the Biology of Boom and Bust (London: Fourth Estate, 2012). Coates’ personal research program combines ‘live’ trading experience and neurophysiological studies. Extremely useful information on the human stress response, mental toughness, and risk stressors that can shape ‘live’ trading or the ‘live’ discretionary over-ride of algorithmic trading systems.

 

Hedge fund and trading system architecture is expensive, and beyond the reach of the retail investor. However, investment in the above books (US$345.32 from Amazon.com at the time of original publication) may give a glimpse of what is possible, from initial idea development (value-based mean reversion) to backtesting, ‘live’ trading, and possible algorithm coding. It’s the information you select; the processes you use; and how your alpha return drivers support the trading system that results from research development, backtesting, and ‘live’ trading.

1st June 2013: Proposal for ISA’s 2014 Annual Convention

The International Studies Association is holding its Annual Convention for 2014 in Toronto, Canada.

 

Below is one proposal I have submitted for consideration by the International Political Economy and International Security sections:

 

Geopolitical Flashpoints, Systemic Risk & Distal-Influenced Spatiality

 

Abstract: Geopolitical flashpoints and systemic risk are now global arbitrage opportunities for hedge funds and political risk firms. Bridgewater (Ray Dalio), AQR Capital Management (Aaron C. Brown), PIMCO (Bill Gross & Mohamed El-Erian), Roubini Global Economics (Nouriel Roubini), and Stratfor (George Friedman & Robert D. Kaplan) have each contributed to media, policy, and practitioner debates about the 2008-10 rare earths bubble, the United States pivot toward Asia, and Iran-Syria-Russia oil speculation. This paper uses develops a Bayesian inference framework which emphasizes distal (far away) and spatial cause-effect relationships, in order to explain how hedge funds and political risk firms as non-state actors can enact global arbitrage and actively influence/shape public debates. I integrate analytical research from the sociology of finance (Donald MacKenzie), international security (Stephen G. Brooks), critical world security (Michael T. Klare & Naomi Klein), intelligence studies (Amy B. Zegart, Robert Jervis, & Gregory Treverton), hedge funds (Andrew Busch & Andrew Lo), and fictional speculation (Richard K. Morgan), to develop a new, inductive theory-building alternative to current explanations that emphasize proximate (near) and temporal causes. This paper advances new understanding about ‘casino capitalism’ (Susan Strange), expert networks, hedge fund activism, and political risk arbitrage.

29th February 2012: StratCap

Stratfor Logo

 

Strategic foresight practitioner Stephen McGrail pointed me to a Yes Men press release on Stratfor/Wikileaks, where I found this gem:

 

Among the millions of other leaked Stratfor emails are some that reveal dubious financial practices, including an apparent insider trading scheme with Goldman Sachs Managing Director Shea Morenz, who joined Stratfor’s board of directors and invested “substantially” more than $4 million in the scheme, called StratCap. “What StratCap will do is use our Stratfor’s intelligence and analysis to trade in a range of geopolitical instruments,” wrote Stratfor CEO George Friedman in September 2011. StratCap was designed through a complex offshore share structure to appear legally independent, but Friedman assured Stratfor staff otherwise: “Do not think of StratCap as an outside organisation. It will be integral… It will be useful to you… We are already working on mock portfolios and trades.” (StratCap has been due to launch in 2012, though that could now change.) [emphasis added]

 

I wrote about Stratfor/Wikileaks here. The StratCap documents are here. They reveal plans by Stratfor chief executive officer George Friedman and colleagues to establish an event arbitrage and global macro fund that would trade on the basis of Stratfor’s geopolitical and strategic intelligence. Friedman and colleagues envisioned a $US25 million fund with a 10% equity investment from Stratfor: small for global macro but possible for a boutique event arbitrage or special event fund. The emails deal with the fund’s offshore structure; the service agreement; the role and compensation of Shea Morenz; and Stratfor’s role to provide StratCap with actionable intelligence.

 

“From where I sit, this deal is dead,” Friedman wrote on 23rd July 2011. The deal show-stoppers included Friedman’s discontent with attorney Bruce Herzog‘s handling of the service agreement and anger over a $US200,000 fee (“for Bruce’s clumsy attempts to undermine the process”); an immediate tax liability that impacted on the initial investment capital; potentially adverse effects on Stratfor’s publishing business and working capital; and the potential for Shea and StratCap to bankrupt Stratfor through demanding potentially unlimited strategic intelligence. These show-stoppers made the deal non-viable: it exposed Stratfor to credit and transaction risks.

 

Friedman explained in his 23rd July 2011 email to Stratfor colleagues:

 

I can imagine easily a scenario in which StratCap’s demands outstrips Stratfor’s means to the point that StratCap would hold Stratfor in default and even push it into bankruptcy with StratCap the major creditor. Nothing in the course of the negotiations gives me the slightest hope that Bruce would not do this in a heart beat and that Shea wouldn’t let him. I regard the proposed service agreement as a threat to the survival of Stratfor as a company under Don and my control. [emphasis added]

 

Friedman notes: “I have no intention of being the Chairman of a failed investment fund . . . I will not be the public image of StratCap, ridiculed for the failure of an enterprise that was built to fail.” (A reference to Jim Collins and Jerry Porras’s influential management book Built to Last.)

 

StratCap may have run into other problems if the fund had launched. In 2002, Goldman Sachs paid a $US110 million fine to separate its sell-side research from Goldman’s trading activities. So did dotcom era analyst Henry Blodget. Morgan Stanley paid  $US125 million in fines though analyst Mary Meeker escaped prosecution. It’s possible that Friedman and Stratfor may have faced similar fines or regulatory threats if they had proceeded with the StratCap deal.

 

Want to start your own event arbitrage fund? You might start with Robert Webb’s Trading Catalysts (London: FT Books, 2006) and Andy Busch‘s World Event Trading (Hoboken, NJ: John Wiley & Sons, 2007) on event arbitrage and special event strategies. On hedge funds, read Sebastian Mallaby‘s excellent history More Money Than God (London: Penguin, 2011), and for the best academic research, Andrew Lo‘s Hedge Funds: An Analytic Perspective (Princeton: Princeton University Press, 2010).

Worth Reading

The emergent theme: mastery of craft and practitioner awareness as vehicles to engage constructively with inter-group, stochastic processes.

· Nu Testaments: James Parker posits that the high-profile religious conversions of Korn‘s Brian ‘Head’ Welch and Reginald ‘Fieldy’ Arvizu are the flipside of drug abuse and nu-metal touring. Will they appear on Celebrity Rehab with Dr. Drew? Will they join the 25th anniversary tour of Christian heavy metal band Stryper?

· Newsted on Metallica: ‘I never looked back’: Good advice from the ex-Metallica bassist on how to handle life after leaving a super-team: make an independent course, don’t live in the shadows of past successes, and keep the door open for future one-off collaborations. Update: Metallica.com’s 3am message and Blabbermouth’s coverage of Metallica’s Rock And Roll Hall of Fame induction.

· Inside a Hedge Fund Meltdown: Hedge fund trader Victor Niederhoffer gives his side of the story about the Refco transaction that led to his ‘blow up’ during the 1997 Asian currency crisis. What a difference a few hours could have made . . .

· Impossible Frontiers: Andrew Lo‘s research sits at the nexus of quantitative finance and practical experience in running a hedge fund, AlphaSimplex. This paper (abstract) co-written with Thomas J. Brennan suggests limitations in the Capital Asset Pricing Model, which determines an appropriate mix of risk and return for a diversified market portfolio, and has implications for funds which rely on short-selling to generate alpha, or investment returns above the market benchmark and vetted for risks.

· Credit Suisse Asian Investment Conference 2009: view the keynote panels and read the conference guide.

· Double Standard? CEOs who want a bailout often adopt the rhetoric of Gary Hamel and C.K. Prahalad‘s book Competing for the Future (1994): government money is necessary for industry survival. James Surowiecki’s ‘paired study’ of the US auto and banking industries shows why the Obama administration’s private equity advisers are pulling the plug: years of firm mismanagement, no profit margins, variable future cash flows, poor liquidity, and international competitiveness.

· Why Your Boss Is Overpaid: Tim Harford’s article was an ‘aha!’ moment on how individual incentives, status hierarchies and infra-group rivalry can sabotage teams. The second ‘aha!’ moment was to grasp how the Australian Government’s recent changes to performance measures in the academic research game are likely informed by tournament theory.

· Henry Rollins’ diary entry 29th March 2008: Some very useful advice on patience and the writing craft: ‘I know a year and a half sounds like a long time and it is but not when it comes to a book. Trying to write has taught me about patience. I remember many years ago, I was living in NYC and working on Get In The Van. I had come back from practice and went back to work. My chair was a bed and my desk was a steamer trunk with a box on top of it. I was transcribing writing out of a notebook and it hit me that in a year, I would still be working on this same book. There is yet another book project that I will start preparing for second draft raking soon if I can get clear on other projects.’

· Xeper as an Operative Secret: Don Webb‘s short essay reveals the Temple of Set‘s initiatory raison d’etre: individual, self-willed becoming. He omits, but has mentioned elsewhere, one powerful psychological framework to achieve this life-orientation (Mihaly Csikzentmihalyi‘s research on creativity, flow and positive psychology) and a very good fictional example of the method and its potential results (Gully Foyle’s transformation in Alfred Bester‘s The Stars, My Destination).

· Event Arbitrage (HBS 9-208-090, 2007): Outlines a two-day M&A simulation and provides details on the market microstructure, merger announcements and transactions. Also explains how to value a ‘negative stub’ alternative investment strategy.

· Managing Learning and Knowledge at NASA and the Jet Propulsion Laboratory (JPL) (9-603-062, 2002): Summarises the lessons learnt from the Apollo moon missions, the Space Shuttle program, and the high-profile failure of several satellite missions in the mid-to-late 1990s. NASA’s KM and organisational challenges included shifting from a heavyweight, waterfall style of project management to the Faster, Better, Cheaper program; the looming retirement of senior staff with organisational memory, and technology solutions which failed because culture, team, and knowledge transfer issues were not addressed. Details a project management office solution which included a budget line item, intranet/portal development, a debriefing process for decision trees and project failures, and a leadership development program. A major outcome is NASA’s Lessons Learned Information System which parallels the US Army’s Center for Lesso
ns Learned
.