In the past year I have discovered that the world of stock trading is full of 'methods'. Bewilderingly so. "Hardly surprising" do I hear you say, "given people have been trading since the dawn of time." What chance has a new method in this churning sea? In fact I found myself asking, is there even such a thing as a new method? Surely the basics are, well, just that, basic. Buy low, sell high. Isn't everything else merely a variant of this simple idea?
While talking with people far more experienced and knowledgeable about the world of finance than I am the same question keeps on popping up. Why is your method better or more reliable than the Leveraged Scalp Chopping technique? Or whatever the latest method might be. Usually I don't have the slightest idea. Either with knowing what a Leveraged Scalp Chopping technique is or how it might even be comparable. Which just goes to show that ignorance really is bliss, until someone tries to enlighten you.
Once the panic dies down I get back to basics. This is done by reminding myself that all we set out to do with the robot was create a means for the average Joe or Jane to make a reasonable return on a part of their capital. Moonshots are not part of the plan.
The goal was not to set out to beat the pants off every investment technique, stock, bond or whatever financial instrument some brain on legs has dreamed up for producing squillions of dollars out of thin air. Our goal in creating a stock trading robot is to help people like us reliably gain some of the benefits of trading.
All we set out to do was buy low then sell a little later slightly higher, repeating this process as often as practical to work the magic of compounding. You probably understand that it took us quite a long time to be able to say it this succinctly, since simple things are always hard to grasp. Complexity is tantalizing and amazing camouflage. But once we got the idea we started looking for this as an underlying premise in the 'methods' on offer. And of course we found it. Everywhere. Mostly it is implicit in the benefits created by following the method. But there it was. Brilliant!
Long before Newton got hit on the head by an apple, everyone knew that if you fell down it hurt. And that if you jumped off a cliff, you didn't go up, you went down - and the farther 'down' was the more it hurt when you finally got there. This implicit knowledge only becomes useful when you can put it to work. Now we knew about gravity as a concept who else had uncovered its workings. What had they to say about compounding in trading?
Compounding has been around as long as usury has been frowned upon by religion. Which probably means this is a very long time indeed. So I went back to the books again and of course searched the Net for more about its wonderful magic. Everyone agrees its magic. Also, everyone is unanimous it should be invoked at every possible opportunity. Unless of course you are the borrower. For the moment lets stick with the creation aspect, since if we have enough income the other aspect of compounding as a borrower need never bother us!
My search was now narrowed down. How did compounding and trading work together?
Follow on questions boiled along. What characteristics does a trading strategy taking small gains and experiencing small losses have? Was it regarded as a risky strategy? Did it give good, bad or indifferent results? If so, what conditions led to each type of result? Is there an underlying theory to guide the unwary?
I could find no answers to these questions. Probably I just didn't look into or stumble across the right place. So my next step was to do what we were taught in kindergarten. Make a model of the toy you want Santa to bring. Someone might just take the hint. On the other hand you also might also enjoy yourself and move along a little and stop annoying the grown-ups.
By this stage we were getting the results in from our first back testing runs. Our research robot, lovingly called Labrat because we regularly dissected it and used its re-incarnations over-and-over, was starting to show the sort of 'interesting' results scientists swoon over. This usually means an interesting pattern ermerges from the noise, hopefully a significant pattern.
While Labrat toiled away at the merciless number crunching the gods of avarice have assigned to him, I fell to modeling in a back-to-basics way physicists love and their wives throw up their hands in despair at. Compared to most performance modeling I have done this really was very basic. Try as I could to make it more complex the more the model told me it wasn't needed. And there in the model's data was the same patterns we were seeing in the backtesting. Eureka!
Once you have a model of a process you have the means of automating it.
Time now to switch analogies. Leave behind Newton, apples and gravity. Bring on airplanes and autopilots and the heady smell of Jet A-1 aviation kerosene on the morning breeze.
The interesting thing about autopilots is they give you the comfortable illusion of keeping your plane on course for Chicago, or wherever you are heading. In uncomfortable reality 90% of the time they only really know what is happening when the plane wanders off-course. If you have the picture of aircraft zig-zagging their way across the skies its not too far short of the truth. Each zig and subsequent zag, is tiny. Feedback keeps it on a track but correction can only be applied when the plane moves away from the desired heading for Chicago. Small adjustments create the illusion of the plane flying in a straight line. The magic in this is the model used to keep control. In the early days of flying pilots would lean out of their cockpit window and using glimpses of the ground adjust their headings by dead reckoning. These planes really did fly zig-zags. The pilot closed the feedback loop. The control model resided in the pilot's expertise. Today they drink coffee and chat up flight attendants! The plane appears to fly itself. Can we do the same for trading?
We labeled the trading strategy we evolved The Barefoot Trader because it had similarities with the back to basics approach of the Barefoot Doctors in the Far East. These practioners relied upon a basic set of proven medical tools, potions and expertise to dispense sound health care to large numbers of people. It turned out to be a very successful model which meant the overall strategy worked because it was built upon workable foundations. The sophisticated medical techniques are still available for the situations they address. In action the strategy ensured regular people have day-to-day benefits from a sound basic philosophy. This felt like a good plan to follow.
Our robot now has its simple model to guide its trading behavior and it can be used to implement a number of trading products. Theory and backtesting match. Live testing is underway and the results I have seen so far from Henry (we have moved on from rats to cats, naming the robots after the numerous felines in our lives) look good-to-go too. He is looking at the NASDAQ in the USA and the FOOTSIE in London and over the next year we will gather the live test results to compare alongside the lab evidence.
So, getting back to that first question: Is there room for another method out there? I believe so. Not so much because it is a better method than any other at selecting stock but because it exhibits a positive trading behavior. It can keep itself on track, know when its gone off track and adjust its behavior to get back on track once again. And finally, and maybe more importantly you don't need to become a pilot to fly this beastie. It runs on autopilot. Just buy a ticket and fly.
