Finding Top Trading Candidates:

Transcription

1 Finding Top Trading Candidates: Tradeoffs in Risk, Reward, and Opportunity September 23, 2014 Adam Grimes, CIO, Waverly Advisors

2 The Problem We have a finite amount of time and attention. Where to best deploy resources? Capital Attention Risk There are, very roughly, 7,000 stocks traded in the US. How to find the best? (Ideas can be adapted to global markets or other asset classes.)

3 Know Yourself There is no one-size-fits-all solution. Who are you, as a trader/investor? Timeframe Risk tolerance Activity levels Sophistication Specialized knowledge Etc. All of these factors, and many more, are important to consider.

4 Outline Refine the question of what to trade by understanding yourself. Consider tools and techniques for filtering trading candidates. Ask hard questions (such as persistence). Look at potential pitfalls and mistakes to avoid. Consider tools that can help.

5 Investment Objectives Make money, yes, but how? We will consider four different types of traders/investors. Active trader, seeking to take concentrated positions Long term investor, adapting traditional portfolio approach Options trader Premium seller Directional trader

6 Long-term investor Seeks diversification Bad things will happen, but with enough positions, it evens out. Ideally, looks for return above index Sector tilts Individual stocks Varying risk tolerances

7 Active trader Needs stocks that will move in certain ways Certain ways depends on trading style Diversification, beyond a certain level, is undesirable Diversification tends toward index return Most active traders find return comes from concentrated bets. Varying risk tolerances and timeframes

8 Option premium seller Needs to sell options with enough premium to be worth it. This is not as hard as might be imagined because the options markets are highly competitive. Ideally, will go beyond technical screens At least, will be aware of corporate events. Specific strategies and structures are outside scope of this presentation E.g., covered calls, straddles, butterflies, etc. Wants stable stocks. Usually wants diversification. (index options?)

9 Directional options trader Wants unstable stocks Relative cheapness or expensiveness of options may not be a consideration Diversification works against this trader

10 Who are you?

11 General Concepts in Filtering Sufficient Liquidity Avg volume Avg $volume Sufficient movement ATR ATR% Relative Strength Stability

12 Why it matters: Liquidity We want to be able to get in and out when we want to, without too much slippage. But, there are some cases in which illiquidity may be a good thing. Trends are essentially one-sided failures of liquidity At least, understand the risk of liquidity and consider how it might change under stress.

13 Measuring Liquidity We use volume as a proxy for liquidity. But is this always good? What might be better? Measuring average bid/ask spread? Time of day influences? Active traders probably want 1MM shares / day. Swing traders might be ok, in some cases, under 500k shares / day. Know your risk.

14 Dollar Volume Average volume, expressed as a dollar amount rather than shares. Two calculations: Average volume * current price Average volume * average price (same period) Maybe more relevant for position traders, but does give better representation of how much capital could be deployed.

15 Measuring Range Many traders will include an ATR screen to remove stocks that don t move. This can be good and bad Even intraday traders, who generally need range, will find good range in news stocks which may have been excluded by any reasonable screen. Markets can trend well, but with very small daily ranges.

16 ETPs Bring Some Challenges

17 Adjusting ATR for Price ATR depends on price %ATR expresses ATR as a % of the underlying price Two very different risk profiles: Stock A: $100 with $1.00 ATR 1.0 %ATR Stock B: $10 stock with $1.00 ATR 10.0 %ATR

18 Rough Guidelines for Liquidity Active Traders: 1MM shares / day $0.75 ATR Position Traders 500k shares / day No ATR screen

19 Relative Strength There is validity to being long the strongest and short the weakest, over a large sample size But there are also some potential issues: Mean reversion can often set in at extremes Naïve application of relative strength often runs into snapback from both strong and weak groups Relative strength rankings will often show strong sector/industry concentrations Many ways to measure relative strength

20 Simple Return Measures In most software packages can use Rate of Change (ROC), which is a simple percent change over a specified time period. ROC = Close today / Close n periods ago 1 A basic relative strength measure can be created as a ranking of these returns.

21 Ranked by One Month Returns Exchange traded products (ETPs) and their related markets show some differences. What happens if we use another time period?

22 Multiple Period Comparison

23 One Possible Solution Rather than use a simple measurement of return, average several periods returns. A good discussion can be found in O Neil (William O Neil: How to Make Money in Stocks, 4 th ed 2009), but many other authors use similar tools. Many options: Use as few as two or many more periods. Weighted or unweighted. Can implicitly weight by period selection: E.g., 1 week, 2 week, 1 month, 1 year is front weighted E.g., 1 month, 1 year, 1.5 year, 2 year is back weighted

24 Waverly Advisors Relative Strength We use a front-weighted multi-period relative strength measure. Periods and calculation are proprietary, but there is no secret sauce. The measurement was crafted to be coherent with and to support our trading style, not because it is better than any other. We use this as an idea generation tool and as a filter for other trades.

25 Multi RS

26 Ranked RS The actual RS value may not be especially meaningful. This shouldn t be surprising: relative strength! Can simply compare a list of RS values to each other to get a RS ranking. It is also possible to compare stocks relative to a stock universe. We do this with a non-parametric ranking: Create the raw RS measure for each stock in the S&P 500 Create the raw RS measure for the test stock. Express the test stock s RS as a percentile of the S&P 500. Can also be outside the range of the S&P 500

27 Ranked RS in Our Research

28 Regions, Styles, and Industries

29 Using Relative Strength Much research shows that naïve relative strength strategies are not effective. In general, academic research shows this, but whitepapers written to support marketing of simple relative strength strategies take a more simplistic approach. Mean reversion is the enemy of a relative strength strategy. Buying the strongest and selling the weakest could leave you exposed to mean reversion. Several ways to compensate, but could begin by filtering for overextension.

30 Filtering for Overextension When markets are stretched far from a moving average, mean reversion is more likely. Need to define stretched far This tendency is different in different asset classes Properly calibrated bands or channels are one way to quantify stretch from a moving average.

31 Waverly Advisors KPos Measure KPos = Keltner Position = the close as a % of the band width. 50% = the moving average 100% = the upper band 75% = halfway between the average and the upper band. Measure can be > 100% or < 0%

32 KPos in Waverly Advisors Research

33 Keltner Channel Statistics

34 Keltner Excursion Stats

35 KPos as a Filter Since there is a statistical edge for mean reversion when a market is outside the channels, one strategy would be to avoid buying or selling markets outside the bands. This would lead to a strategy that is similar to trading pullbacks. (Realize these tests work with a wide range of parameters. The concepts are much more important than the details.)

36 Stability Consider this progression: Point changes ($1.00 but on a $5 or $200 stock?) Percentages (1% is standardized, but is that a lot for this stock or not?) Volatility-adjusted measures ATR ratio SigmaSpikes

37 SigmaSpikes Expresses each day s return as a standard deviation of the previous 20 trading days. Not normally distributed! You will have plenty of +/-5σ days, for instance

38 SigmaSpikes on a Chart

39 Some Markets are Asymmetrical

40 Stability in Our Research Keep a running total of how many large SigmaSpike days over the past 252 trading days. Few may indicate a quiet (statistically, more predictable) name. More may indicate more volatility. 4/252 quite likely earnings-driven This measure tends to be stable, but surprises happen.

41 Stability Measure

42 How to Use Stability Large shocks disrupt options pricing This is good for long premium traders and bad for short premium Can use as part of selection process and risk management. Remember, all statistical measures only work within the bounds of probability. Surprises happen.

43 Screening Tools in Waverly Advisors Research Equity Trading Model Active stocks Tactical Equity Screens Big Movers In Play Consecutive Closes RS Strong Consolidating Near Extremes weekly

44 Waverly Advisors Screens

45 Active Trader Focus on Equity Trading Model Tactical Equity Screens Extension Consecutive Closes In Play Big Movers Position screens Consolidating Near Extremes RS Strong

46 Long-term Investor Market and risk environment context is important Sector and geography tilts Specific stock names Consolidating near extremes RS Strong In Play (possibly more short term) Equity trading model (actives)

47 Options Traders Use screens for your timeframe Risk and market assessment matters Focus on stability measure that fits your chosen strategy Long premium players probably prefer more shocks Short premium (long time, etc) prefer more stability

48 Summary Before launching into screening and filtering (which is made very easy with software) think about who you are as a trader. What are you trying to accomplish? How will you get where you are going? Understand the tools and techniques, and potential issues with each of them.

49 Waverly Advisors Research Specific systems, broad tendencies, and actionable ideas in major liquid markets. Futures Currencies Stocks (indexes and individual names) Both trend-following and counter-trend components. Applicable to traders working on all timeframes. Daytraders swing traders investors

50 Waverly Advisors, LLC: Research Products Tactical Playbook Available on Interactive Brokers Written for the active trader on the daily/weekly timeframes Exact trade recommendations Hybrid systematic-discretionary methodology In-depth technical drill down into a set of markets. Bigger-picture overview of all liquid asset classes. Tactical Portfolio Outlook Available on Interactive Brokers Written for the longer-term manager Addresses both the allocator and the longer-term active trader. Emphasis on executing with ETFs in a long-only and long-short environment Focus on Equities, Equity Sectors, and other asset classes Macro perspective on risk factors and major economic events. Options Market Outlook Contact Waverly Directly Proprietary, quantitative analysis of options market Incorporates both volatility and directional analysis Macro risk factors and cross-asset perspective Actionable trade ideas

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53 Contact: Adam Grimes CIO, Quantitative Analysis, Risk Management Waverly Advisors 228 Cedar Street Corning, NY Chris Noye Managing Director, Head of Sales (607)