Trading | Portfolio Yoga

The one minute Challenge

A systematic trader faces several dilemmas when he is trying to figure out the best time frame he should use. Should he go with a 5 / 15 minute bar where he will get a lot of signals or should he chose the 60 / 120 minute bar where signals are far less.

For those trading the hourly / 120 minute bar, a secondary question arises. Should his bar start at 9:00 in the morning (even though trading starts at 9:15) and hence have his first hourly bar reflecting 45 minutes and the last hourly bar reflecting last 30 minutes of trade or should he start his bar construction at 9:15 in which case, he will have to deal with the problem of having his last hourly bar of just 15 minute duration (3:15 to 3:30).

A optimal solution recommended for the Indian market scenario is to have 75 minutes and start bar construction at 3:30. This way, all bars are uniform in nature. But 75 minutes is not exactly something you come across in any technical literature. Its just a number that is at the current moment the best way to divide the Indian Market timings into equal number of bars.

While you may wonder as to why such small difference as important, a simple back-test shows how varied the results are for the various time frames and the difference based on the starting bar.

Lets take a simple 3 EMA by 5 EMA system (trade price being the close price) and see how much of a impact the starting time will make to the overall returns. Test period is from 0.1.01.2010 to 31.12.2014 – Nifty Rolling Futures

As you can see, its more or less evenly split. For the 30 minute bar and the hourly bar, backtesting seems to indicate that using 9:00 as the starting time frame would be best suited. On the other hand, if you were using the 75 minute or the 120 minute bar, using 9:15 would be the way to go.

Now, let me complicate things a bit. Should your bar start at 00:00 or 00:01. For example, should the bar reflecting the data between 10:00 – 11:00 start at 10:00:00 & hence end at 10:59:59 or should it start at 10:01:00 and end at 11:00:59 ??

You think I am kidding, well lets take a look at results, shall we

If you are a trader using 30 minute bar or the 120 minute bar, the difference is staggering to say the least. Its no kidding matter to see your results poorer by 32% just because you chose to move the time by 1 fricking minute.

Intraday trading (even of the positional variety outlined above) is tough and its no small matter as to how small changes in where the bar starts, where the bar ends and how long a bar should represent can dramatically vary the end results. Reminds me of the Butterfly effect.

So, what is the solution? Unfortunately, there is no easy way out. You may think that using End of the Day bar can eliminate such things, Right? Well, most systems that are tested on End of Day time frame use the adjusted close and good luck on being able to get in and out at the adjusted close prices. As to those who use Open of next day, you will need a co-located Algorithm system to even be able to come close to buying / selling at those prices.

The idea of this post was not to showcase what is right and what is wrong, but to provide you with data to show how small things can make major differences and hence the next time you think about extrapolating something, do keep this in mind.

Capital Requirement for a trader

When one starts any business, one has a pretty clear idea as to what would be the cost of starting the business. This may go from a few thousands (if you are starting a web based company) to a few crores (say to get a start in the construction business). But when it comes to trading, there is not much of clarity on what capital is required. This post is a attempt to calculate what you will need if you want to get into the business of trading for a living.

The biggest negative of trading for a living is the fact that the number of failures are humongous in number. I have been in the Industry for nearly 17 years now and I do not know of a single trader who was active when I started off and is still active as a trader now. Of course, there will always be folks who have been active for even more a period of time, but the numbers will be pretty small in nature.

One of the key reason why many a trader cannot sustain this venture is due to lack of a viable strategy. It does not matter how big a capital you start with, if you are chasing the wrong end of the stick, you will end up suffering total capital loss.

A second reason for many a trader to be unable to sustain this business is due to them starting with insufficient capital and then hoping to make a living of it. Markets are not a cow that will provide milk every day or a tenant who shall provide the landlord with a monthly income. Even the best of traders go without having a income (or even worse, having a loss) for months together.

Stress for the trader is guaranteed regardless of the methodology he follows if he has a payment to make and markets are not providing him with the moolah. Many a advise I have heard is to keep 3 years of expenses in a separate account so that you are not troubled by the lack of ability to buy milk the next day because you are having a streak of loses and cannot afford to withdraw capital at this juncture.

I constantly keep meeting traders and the one thing that is constant among many is that they are very well capitalized. This with a decent strategy assures that one will be able to survive the thrills and spills that accompany a traders life.

So, what would be the ideal capital for a trader?

The answer actually is dependent on a lot of factors including the style of trading. For example, capital requirements of a intra-day trader is very small compared to a positional non leveraged trader.

I did a small exercise as to what is the optimal capital requirement for a trader and the results are as shown in the pic underneath.

The above expenses sheet are based on my assumptions on what would be the cost that one needs to account for.

While the costliest data feed would be having a Bloomberg Terminal, I have assumed that not many a trader would actually go for that and instead based it on eSignal. I personally use Global Data Feeds and the amount I pay comes closer to the Average.

So, considering the above expenses, what is the capital requirement if one assumes that the system will over time generate X% / year (not consistently, but on a long enough time frame).

Most simple strategies do not beat the markets and this means that while its nice to be optimistic and think of generating 4 – 5% per month (48 – 60% per annum), in reality you shall find the returns somewhere between 1 – 2% per month (12 – 24%).

Assuming that you are a Average spender, that would mean that you would need a minimum capital of 2 Million to start with. And since we cannot be pulling out money month on month, you would need to store away half a million so that you do not have to worry about your expenses for a year at least. Totaling that up, you will need around 2.5 Million Rupees for one to get started.

The biggest disadvantage for a trader who needs to dip into the capital for expenses (removal even every year) is that he literally misses out on the Eight wonder of the World – Compounding.

Without compounding of capital, there is really very little of wealth generated over time and while you may feel confident that you can continue to do this till the end of your life, it does put a pressure on one to be correct as far as possible.

The biggest advantage of a trader is the ability to lead a life without having to stick to one place. You can travel around the world and yet continue to make a living. In fact, a guy whose website I recently stumbled upon seems to do the same thing and has claimed to have traveled more than 80 countries even as he day trades for a living. (Link)

At the same time, I have first hand witnessed financial destruction and even death of traders who were not able to sustain themselves. As I wrote in my previous post, the probability of survival for a trader (if this is his only source of Income) is pretty low. Just like not everyone can make it to the IIT, so is the ability to earn a living just through trading.

But if you can succeed, there is nothing more satisfying out there. No clients to argue with, no payments overdue, no employees to worry about. Hell, one is truly one’s own boss and driver of his destiny 🙂

Travails of a Trader

Trading is not just a risky business to be in with a survivor rate of less than 5% but a expensive one as well. Most traders are engaged with the markets on a full time basis which means that they cannot earn a living elsewhere. Of course, a lot of guys do trade from their office, but most of them are there for the thrill rather than engaging in the act of earning substantial returns from the investment they make. Of course, like any other field there will always be outlier’s who are not only able to trade successfully but also hold a good paying job elsewhere.

The whole playing field is actually loaded against the trader. Take taxes for example. A investor who holds a share for more than 1 year can enjoy the gains without paying a cent in taxes, traders pay taxes at multiple levels.

Whenever a trader transacts, not only does he pay the brokerage charges but also pays Service Tax on it and Security Transaction Charges. While a investor may deal very few times, a trader by nature is active on most days (depending on the strategy he follows) and hence ends up paying a pretty packet under these accounts.

While earlier, it was essential for a trader to sit at a brokers place, with the advent of internet trading, this is no longer necessary though even today, you shall find clients sitting behind the dealer and placing their trades at may a broker’s office. But if one were to trade outside the broker’s office, it requires a place where you can sit and trade without being disturbed.

While many a trader works from home, professionals generally prefer a quieter place since unless the house is empty during the day (trading time), its tough to avoid disturbances from family members no matter how much one tries to avoid. Add to that, trading not being recognized as a activity in itself, a person at home is generally seen as unemployed rather than self employed.

Once you have a place of your own, the next in line is the investment one needs to do to ensure access to a trading terminal through the day. This means a UPS to ensure that power failure does not affect one’s trading as well as Internet connection to be able to connect to the brokers server.

While a single laptop + a broadband connection may be good enough, most traders prefer to have some redundancy build in for that rainy day when one suddenly finds that not only is his system switching on, but a damaged cable has meant that he has no access (virtual)
to the outside world.

Building redundancy is expensive but can save one’s butt when things go awry right from the world go. Just to recount a personal experience I had recently, my main system suddenly crashed and my system guy informed me that I will need to reformat and re-set up the whole thing right in the middle of a trading session.

Since I have a secondary system, I did not bother much at that time and continued working from the other system. A hour into that, the SMPS of the back-up system literally went up in smoke. Talk about coincidence.

Most traders use Technical Analysis as their trading tool and this means investment in Charting Software + Live Data Feeds. Of course, you do have internet based charting data providers as also free live data providers, but if you really want to test ideas, you would need to invest in them. And even there, one may need some redundancy. Today for example, right when the market was crashing, Global Data Feeds server crashed. If I were to have had a big long position during that time, I would have had no way to know whether to hold the position or exit and short the market.

While most traders I know trade with only one broker, bigger trading friends of mine actually trade at multiple places to ensure that in case a broker’s server goes down (for any umpteen reason), they are able to hedge themselves somewhere else. After all, if you were holding 10000 Nifty (400 contracts), you cannot wait for the brokers server to be reset even as the market starts to move against your position.

Trading as a hobby (which is what its for many) is a pretty expensive sport to be in. Above are some of the issues that needs to be thought into before you jump into a trade. And even after doing that, you may end up having the worst luck and getting killed because you could not get out of your positions fast enough.

Most traders get killed not just because they lack a strategy worth trading but also because they are highly under-capitalized while at the same time trying to earn a full time living out of it. In a future post, I shall detail what I think is the minimum capital a trader needs to start off with if he wants to survive for a period longer than the average trader.

Exception to the rule

Today I read a tweet by a person who claimed that he was posting his ledger just to showcase to those who believed that “Day traders loose” that its indeed possible to make good money trading purely on intra-day scale. While I have not met him, I do take his word on faith and assume that he is indeed pretty successful in trading the markets on pure intra-day basis. And there is this friend of mine who has build a fortune (by his standards, not Fortune’s) by just being street mark and networking with the right folks.

In November of this year, a 4 year kid fell 230 feet and survived (Link). Lots of people make money in Casino’s as well despite the known fact that “the house always wins”. And this without having to do card counting.

I know plenty of long term investors who have not been able to out-perform a simple Buy & Hold returns of Nifty and even worse, many have fallen by the way side having lost a major part of the money in stocks that today are no longer even available for trading.

Vastu / Astrology are seen as bunkum, but I can show you guys whose careers have changed because of a change in the direction of the door. And there are enough people who strongly believe that homeopathy can cure a lot of diseases.

The single thread between all of them is that they are all exceptions to the rule. If no one ever made money (in short term if not over years) trading on intra-day scale, people would never try to do such stuff. And if no one won in a casino, they would have to shutter for lack of clients.

But exception to the rule does not mean that its easy for others as well. If day trading was really easy, I would doubt anyone would want to work anywhere else when you can literally make mind-boggling returns on capital (Day trading requiring very little capital is the biggest attraction).

If access to news / information ensured a success in markets, the richest folks would be those who have the first access (think of people working at Newspapers, Television studios).

If all our problems can be solved by simply changing the direction of the door, well, you should have seen that happen long back and by now we would be living in a state of Nirvana.

Beating the market is very tough and very few people are able to do that consistently year after year. There is no magic wand that can let you make tons of money without you having some amount of expertise. And the guys who have achieved that success, its not due to luck but more due to hard work and persistence. If you were to read about Sachin Tendulkar or Tiger Woods, the common thread between these guys were the fact that they were not only in the right place at the right time but also that they put efforts more than what others did and as Robert Frost would say, that made all the difference.

The case for Draw-downs

The biggest worry for a Systematic Trader is the Draw-down number. Bigger the number, more he worries about his ability to trade the system since it can be psychologically difficult to maintain composure when a large part of the capital has been temporarily lost. I say temporarily because unless you throw the bath water with the baby, a good system will always see the previous high being re-claimed in due course of time.

Lets face it, you shall face a draw-down no matter which class of asset you put your money in (exception being Fixed Deposit). Equity Mutual Funds / Debt Mutual Funds even Real Estate face a draw-down at one or the other point if one takes in a sufficiently large time frame.

Many mutual funds for example had a draw-down of more than 30 – 40% when the financial crisis hit the market and this is un-leveraged. Many stocks on the other side hemorrhaged as they lost greater than 50% as the crisis dragged on. So, deep draw-downs are not uncommon no matter what class of investment you choose to make.

The reason for the thought to write about draw-downs came to my mind basically due the exchange of tweets regarding draw-down in Titan during the 2008 financial crisis between Professor Sanjay Bakshi & Debasish Basu (Link). The stock under discussion was Titan which between its high in 2007 and low in 2009 fell by around 62.75%. If a 62% draw-down lasting more than 15 months will not psyche out someone, I doubt anything else can.

Its amazing that while we face draw-downs everywhere, including in life. its only in financial markets that we become paranoid and unable to grasp the longer term picture. Of course, even in life, weak minded people facing a stiff draw-down think of ending the life to end the pain, but for the vast majority, we some how are able to make up for everything and get back to our feet.

Being a very strong believer in systematic based trading, I regularly test ideas that either I develop myself or read about it somewhere else. The one thing that is common in most winning strategies is the huge draw-down. You cannot aim and possibly get 40% return without being ready to risk a draw-down of 60% – 80%. While its easy to talk about Risk to Reward ratio being at least 1:2 if not more, when it comes to draw-down, its always inverse.

One of the questions I am regularly asked is, How can I reduce the draw-down without it affecting the returns in a major way. Unfortunately, markets is all about give and take, you want to reduce draw-downs, you will face reduced returns as well. Just in case if you are wondering as to whether there exists strategies that have a very low draw-down while still having fairly good results, there are.

One is a heavily data-mined strategy which ensures that your historical draw-down is pretty low while compared to the historical returns. Of course, once you start trading that in real time you suddenly see that while the returns remain the same (at best), the draw-down goes completely off scale and unless one has prepared for it, chances of the system bankrupting the user is pretty high.

Second way is if you can game the system. While there is quite a bit of debate on whether HFT’s are gaming the system, I doubt you can have a record like that of Virtu Financial which had just one day of loss (and that too due to human error) while accounting for 1237 days of profit. While Arbitrage is said to be having low risk, this is something of a Zero Risk which is theoretically impossible (free money anyone?) unless they found a way to game the system.

Coming back, I believe that traders are more scared of draw-downs than Investors for two reasons. One, the trader is using leverage which easily balloons up the losses in a short span of time. Investors on the other hand generally have invested in full and would need to pay no more regardless of where the price goes. Getting a call from your broker to arrange for Marked to Market loss every other day can take a toll.

Secondly, a investor can avoid looking at the market for extended period of time during which the price may have come down and then bobbed up while a trader would be stuck to looking at every tick and hence pass through the emotions much quickly. If you are having a position which is under-water and loosing money every day and you hear the talking heads on TV giving out targets which would normally be preposterous, its tough indeed to sit quietly and wait till the things calm down.

Of course, does that doesn’t mean that a Investor is a winner in most situations while a trader is not since we have not accounted for a lot of cognitive biases that affect the way we look at things in life. I for one believe that a trader can compound money much faster than any investor (remember, Leverage is a double edge sword) but that is only if he is able to look at things not in the way its presented but in the way, its impact on the future is.

To Conclude, a Big Draw-down is not necessarily bad and in the same way a small draw-down may not be necessarily good. Its all relative to something else (all the time) 🙂

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