Sunday, August 15, 2010

Mr Market

I came across a very interesting take on Metaphors for market , and this is what is says

Mr Market

"Warren Buffett was the first person that I heard refer to the market as Mr. Market. It just hit me as the most accurate assessment. Trading is still predominantly male. And thus Mr. Market became my favorite metaphor for the market.

My sister has had to listen to countless hours of my trading trials. (which should qualify her for sainthood). She was well aware of my proclivity to call it Mr. Market. One day she told me, “It’s like you’re in a bad relationship with the market. He’s treating you like crap, doesn’t really care if you exist, does his own thing, and lies to you. Dump Him!” Brilliant. And the golden rule of trading appears in another form.

My Golden Rule in trading is “Dump Him!” – aka “Cut your losses short.”
"

Wednesday, August 11, 2010

Does Averaging-In Work? Case Studies by - Ron Schoenberg and Al Corwin

Does Averaging-In Work? Case Studies by - Ron Schoenberg and Al Corwin


Ron Schoenberg and Al Corwin recently did some interesting research on the trading technique of "averaging-in". For e.g.: Let's say you have Rs4 to invest. If a future's price recently drops to Rs 2, though you expect it to eventually revert to Rs 3. Should you

A) buy 1 contract at Rs 2, and wait for the price to possibly drop to Rs 1 and then buy 2 more contracts (i.e. averaging-in); or
B) buy 2 contracts at Rs 2 each; or
C) wait to possibly buy 4 contracts at Rs 1 each?

Let's assume that the probability of the price dropping to Rs 1 once you have reached Rs 2 is p. It is easy to see that the average profits of the 3 options are the following:
A) p*(1*Rs1+2*Rs 2) + (1-p)*(1*Rs 1)=1+4p;
B) 2; and
C) p4*Rs 2=8p.

Profit A is lower than C when p > 1/4, and profit A is lower than profit C when p > 1/4. Hence, whatever p is, either option B or C is more profitable than averaging in, and thus averaging-in can never be optimal.

From a backtest point of view, the Schoenberg-Corwin argument is impeccable, since we know what p is for the historical period. You might argue, however, that financial markets is not quite stationary, and in my example, if the historical value of p was less than 1/4, it is quite possible that the future value can be more than 1/4. This is why I never make too much effort to optimize parameters in general, and I can sympathize with traders who insist on averaging-in even in the face of this solid piece of research!