# Stock market and insurance



## hyunski (Mar 21, 2015)

Hi everyone,

First post on this website and wanted to get some input on a theory I had and prevent other people from making the same mistakes I made when I started off my trading account. Ever since I've started trading I've been obsessed with the subject and studied the stock market from different angles. Fundamental, technical, macro, you name it. I blew my first account in forex, the next one investing in value stocks, and my third is finally profitable.

Right now I study stocks at a statistical angle where I try to exploit patterns in human trading behaviors, and came up with a theory that all you should be looking to do is sell insurance on these statistical edges. Here are my assumptions:

1. Short-term prices are more predictable than long-term prices (fly out of a jar example).
2. Prices are determined by the beliefs of buyers and sellers.
3. Buyers and sellers display behavioral patterns.
4. These behavioral patterns can be quantified and are persistent over the mid-term.
5. If I diversify, I can build a portfolio that can generate predictable returns over the long-term.

It is similar to insurance theory in that I am stacking the numbers in my favor, diversifying and relying on historical patterns to forecast the future. After I've discovered this "truth" in the stock market, I've come to realize that this is my trading style, and this type of style can be found across other professions as well. For example, you have the tactical vs positional style in chess. Another example is in racing: James Hunt (tactical) and Niki Lauda (positional). There are those tactical geniuses who can intuitively feel the right trade and there are those who must analyze reliable, repeatable patterns to commit to a trade. In trading the contrast would be between someone like Soros and Niederhoffer. 

I wonder if this is what the term statistical arbitrage means, but I've never learned it from someone else and there isn't too much information online (even if there were, probably outdated and irrelevant like older technical analysis). Has anyone else come to similar conclusions on the market? That it is all fairy dust and irrational to invest in stocks at all, but only that you should exploit this belief? That unlike commodities stocks only serve a financial use instead of physical consumption?

Read around and seemed like there are a lot of smart people here (better than trading forums), let me know what you think.


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## Razare (Apr 21, 2009)

hyunski said:


> That it is all fairy dust and irrational to invest in stocks at all, but only that you should exploit this belief?


The valuations aren't all fairy-tale.

Companies can be and are purchased through stocks, so you can assign a hard and fixed value to the company.

The problem is that companies diverge a great deal above and beyond their actual value. This fluff is something I generally consider a fairy tale in investing. 

It's fine to buy into fairy tale valuations so long as you have a plan to profit off of it. Yet you can't keep believing in the fairy tale when the magic is gone. It's only when the market crashes that their fairy tale valuation disappears and companies realize their actual values, sometimes going below that value even and trading to a discount.

As an accountant, I generally only buy a stock if I can determine a market cap value to the stock, that it will trade to in its future, if XYZ conditions are met. Then it is only a question of whether those conditions are met.

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In general what you are describing has merit as a strategy, though.

I read a book and they shared some of the things that worked for them, and one of them was trading the VIX. For a time, they could make money swing-trading the VIX, and there is probably a way to still do it now, just more complicated because the knowledge has disseminated.


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## 7rr7s (Jun 6, 2011)

It can be mapped using the golden ratio.


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## hyunski (Mar 21, 2015)

I should specify the stocks I'm trading: small cap under $15 which is prone to fairy dust. Blue chips are more diversified as a business and valuation can be largely stable because they are in the mature stage. Small caps are growth oriented and rely more on future expectations. Small cap stocks generally rally (historically) from M&A, new product/technology and public hype. Large caps generally rally from earnings expectations and macro conditions. This is not my opinion, but observations made from last half year of screening for stocks that have rallied the furthest and identifying why they went up.

Also there seems to be some kind of transitive state on the stocks. Even blue chips will sometimes rally on merger talks or new products, moving away from their general state of being impacted by earnings expectations.

I don't mean to insult but I now believe that seeing the market prices as irrational is itself irrational. I've graduated with a finance degree so I've been drilled into my head about the theoretical values of companies and why they should be $X. The problem with this thought process taught by academia is that the point in their thinking is not to maximize profits but to find the right theoretical value. The goal of any trader should be to maximize one's own profits where profit = avg return/trade x # trades.

I see that large hedge funds cannot trade short-term due to liquidity reasons and have an information edge against the public, so they favor fundamental methodologies because that is their edge. They know their strategy won't yield 300%+ returns, but they use leverage to cover that weakness. I briefly cover the thinking behind this in my blog gamblethemarket.blogspot.com under "Dots and Triangles." If there is no liquidity restriction, the trader seeking maximum profit should be constantly looking for patterns to exploit that are the most profitable whether or not the pattern is fundamental or not.

I do see your point, though. When big transactions occur (M&A) companies are fundamentally valued to confirm the market price by valuation analysts. I guess small transactions (stock market) don't receive this scrutiny and are often off value.

Although I should point out that valuations rely on assumptions such as discount rates or growth projections that rely on the different perceptions of the people who value it. Even market metrics such as P/E or P/BV rely on P, which is determined by market participants, of whom not 100% are fundamental investors. So I think there may be sprinkles of fairy dust even in the most objective valuations.

And because I don't get interested in a stock unless I want to buy/short it, I can never be 100% objective when I run the analysis on it when I am already interested in it. I've reached this conclusion after going through a trade that I was so sure on fundamentally, and as confident in placing the trade that I had made 550% in, and losing 80% on it. After the success I had, I was looking for another big trade and held that bias into my next analysis. If I know the numbers, and follow a strategy that follows numbers, it would actually be difficult for me to hold any bias, which helps my trading psychologically.

Also, estimating the position size (kelly) on fundamental valuations is difficult and can lead to ruin because there are so few trials available to extract meaningful odds from. If I had 20 trials of the almost same situation I can calculate my position size, but how can I do this when I place less than that in a whole year? I can diversify 20 positions and hold them for a year, but even so the resulting data is not from flipping the same coin N times, it's flipping N different coins one time.

Too much thinking here but hopefully it shows why i'm leaning towards more consistent short-term returns over bigger swings. Kind of like going to McDonalds in France over trying out their cheese corner.


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## Father of Dragons (May 7, 2012)

First off, I just wanted to say that there probably aren't many people in this forum that could really have an even discussion with you about this. Might I recommend tracking down a trading forum or something? I'm sure you would get more of the level of informed input you are seeking.

It seems though, like you are trying to develop a trading system? As far as I know there are a gazillion out there. I actually read an article recently on how computerized trading systems are some of the most dominant market movers in the short term. It seems to me like a system like yours might benefit from such a treatment? You could perhaps run simulations over a period of time to gather data like you are mentioning at the end there?

Also, if you graduated from finance, I'd imagine that you've come across behavioral finance before. You should try to find information on the applications of it to investing, as I'm sure it would be relevant to your framework. For instance, I know that some hedge funds have systems based on expected behavioral responses to market events, shocks, etc. I know a lot of traders, day traders etc. implicitly adjust their expectations on how they believe people will respond to events, but it might benefit you to explore more systematic applications.

A lot of your ideas do sound reminiscent of Soros though, who you mentioned. He believes that the price affects fundamentals affect price. Ie, markets are inefficient, and expectations shape the financial landscape, rather than fundamentals. Judging from his success it's hard to believe that the markets are perfectly efficient, in which case there must be room to exploit those moments when equities are not mis-priced, in the belief that they will correct. Or, alternately, that they will deviate further from their "proper" valuation due to speculation and/or irrational expectations, in which case you might ride the speculation train in the hope of selling before the "bubble" bursts and prices track towards a more sustainable level. 

Anyways, I'm not sure if any of what I've said is helpful, because I am quite a noob when it comes to finance, at this point. I feel like you are exploring some pretty high level ideas, so I'm not sure if my input is altogether helpful.


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## bluekitdon (Dec 19, 2012)

hyunski said:


> Hi everyone,
> 
> First post on this website and wanted to get some input on a theory I had and prevent other people from making the same mistakes I made when I started off my trading account. Ever since I've started trading I've been obsessed with the subject and studied the stock market from different angles. Fundamental, technical, macro, you name it. I blew my first account in forex, the next one investing in value stocks, and my third is finally profitable.
> 
> ...


Personally I like Warren Buffett's thought - when you are buying stocks you're buying a business. If the business does well you'll do well over the long haul, assuming you get the stock at a reasonable price. If you can't understand the business don't buy it.

I'm curious, what type of return are you getting if you look back overall for the last few years? Is what you are doing higher than index returns at least or do you really have results that long term to look at? I have had bubble years in the past doubling my money using a combination of looking at fundamentals, historical earnings, and the company as a whole but then others where I didn't beat the index using the same methods.


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## hyunski (Mar 21, 2015)

I love the input from both, regular trading forums have something against thinking (most posts are about marketing their believed strategies that adjust input parameters instead of figuring out how the system works: ex. if i adjust my moving average to 14, it is better than 34! me: of course you idiot if you adjust your assumptions to fit the past data!). Data isn't conclusive because it has 139 trades and was run only from 3/2/2015. But here are the statistics from forward testing with a real account:

N = 139
Win % = 61%
Avg Win % = 2.4%
Avg Loss % = -2.1%
Standard Dev = 3.1%

Net return = 12.4%
Correlation w/ Kospi = -0.77
Correlation w/ Kosdaq = -0.29
Max drawdown = -3.7%
Profitable days % = 75%
Avg daily % = 0.7%

I'm thinking systematic trading is on a down trend as well. Any kind of static system will always have flaws because people will take advantage of the resulting patterns. This is probably why high tech hedge funds are hell bent on doing machine learning. For example, trend following has been hard hit since the strategy is similar despite individual differences, and many CTAs have jumped on it. Value investing is outdated in my opinion as the effect of larger globalization is now beginning to ignore value and leaning towards macro trends.

An analogy is a port full of ships. When there are almost no waves, the best ship picker will have to know the individual differences among the ships. When there are more frequent waves (larger global inter-dependencies), the guy who can forecast the bigger tides will win. Because the "value market" is now becoming efficient enough, the guy who can pick out tides can anticipate the wave, look at sector movements, and choose the stock to buy that other participants tell him is the best choice (thus making the value funds "work" for him).

Behavioral finance is interesting but is too theoretical and makes static assumptions on a system, which is the same thinking process mistake made by "rational market" theorists...they are just taking the other side. It's like building a straw man to support/take down an argument and realizing that the straw man shifts forms 

I also see a lot of the historical patterns disappearing. It used to be the case that if you bought when resistance broke on a hyped stock, you would see substantial returns. You will notice that rallies actually usually end here as traders take advantage of people who hold this old belief. This pattern still only holds true in penny stocks because sophisticated traders who have larger bank roll can't put their money to work.

One thing I do not like about long-term trading/investing is that I can't achieve consistency or improve my strategies quickly enough. For example, a 2-year long idea will take 2 years for me to figure out that it was right/wrong and I would not be able to improve my strategy within that period. Also, I would not know at a longer time frame if the result was from luck or skill (higher uncertainty as time progresses as new variables are introduced into the original trade, and fewer observations/trades).

I am also usually skeptical of well known conventions because they imply that people were intentionally led to believe them for some motive, good or bad. Ex. If I were really good at trading and was asked repeatedly to write a book on my working strategy, the best risk/reward choice would be to write one on a strategy that doesn't work: mislead competition AND make book sales. Not that Buffett does this, but it's a healthy thought.

The way I see it is that I am trying to learn the system, and hack it until the vulnerabilities disappear. You can program a machine to exploit these more efficiently at an operational level, but you can't program it to think for you to create a grand strategy (not yet or I'm unaware of it). Anyways, the point of me posting stuff here is that I'd like to bounce off conceptual ideas and see what other people think of the correctness in my thinking process instead of trading specifics.


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## bluekitdon (Dec 19, 2012)

It would be nice to be able to predict short term ups and downs as stocks do fluctuate wildly in the short term. That being said, I'm not convinced that is entirely possible, and the big guys are spending millions trying to do that. The people that win on short term strategies in my mind are the brokers, they get paid regardless of whether the stock goes up or down, they get paid on volume of trades. 

Hopefully your strategy works for you, I'd just keep a close eye on your long term returns as the vast majority of actively managed mutual funds which hire managers to do this full time do worse than index funds after all the expenses for trades and management expenses are taken into account.


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## hyunski (Mar 21, 2015)

I'll keep this thread updated and let you guys know what the performance is. Hopefully I'll see consistency over the next year.


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## bluekitdon (Dec 19, 2012)

hyunski said:


> I'll keep this thread updated and let you guys know what the performance is. Hopefully I'll see consistency over the next year.


Just don't forget to factor in trading expenses. Not sure how big of chunks you are trading around, but $10 is a common expense to make a trade, that's 1% of $1000. Pretty easy to eat up any gains with trading fees especially on small trades.


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## Razare (Apr 21, 2009)

hyunski said:


> I love the input from both, regular trading forums have something against thinking (most posts are about marketing their believed strategies that adjust input parameters instead of figuring out how the system works: ex. if i adjust my moving average to 14, it is better than 34! me: of course you idiot if you adjust your assumptions to fit the past data!). Data isn't conclusive because it has 139 trades and was run only from 3/2/2015. But here are the statistics from forward testing with a real account:
> 
> N = 139
> Win % = 61%
> ...


I think this trend is great for the fundamental investors, though.

There is nothing better than having computer equations crash the market down to valuations below net book value. That's so long as you have money on the sidelines before the crash.

I remember in 2008/2009, there were companies that approached their cash per share levels to a degree never seen before.


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## hyunski (Mar 21, 2015)

Yup commission is factored in the performance (net return). It's 0.33% round trip in korean equities.


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## hyunski (Mar 21, 2015)

Update on performance 3/1/2015 to 4/6/2015:

N = 215
Win % = 57%
Avg Win % = 2.4%
Avg Loss % = -2.0%
Standard Dev = 3.0%

Net return = 17.0%
Correlation w/ Kospi = -0.49
Correlation w/ Kosdaq = -0.12
Max drawdown = -3.7%
Profitable days % = 73%
Avg daily % = 0.6%

Grinding away...


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## hyunski (Mar 21, 2015)

Update on performance 3/1/2015 to 4/17/2015:

N = 247
Win % = 59%
Avg Win % = 2.6%
Avg Loss % = -2.1%
Standard Dev = 3.1%
* Note: not weighting by position size if you were wondering about inconsistency between this and below stats

Net return = 26.9%
Correlation w/ Kospi = -0.27
Correlation w/ Kosdaq = -0.09
Max drawdown = -4.0%
Profitable days % = 69%
Avg daily % = 0.7%

Great week and a half.


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