Is your stradegy skewed ?? here are some things to take care before start developing
Regarding your sentence " It makes consistent money, but occasionally realizes a dramatic loss", how much do you consider a dramatic loss?
I've seen in fund's statement - they hold long term positions on stocks - that they closed a position whenever loss was more than 10%. Another example, talking with guy from a forex fund, he told me he alwais put at risk in forex less than 0.5% of their assets. This would mean they could handle two hundred dramatic losses of 100% each before bankrupcy.
Therefore, is a "skewed trading system" one which lacks a sound money management strategy?
AM
Regarding your sentence " It makes consistent money, but occasionally realizes a dramatic loss", how much do you consider a dramatic loss?
I've seen in fund's statement - they hold long term positions on stocks - that they closed a position whenever loss was more than 10%. Another example, talking with guy from a forex fund, he told me he alwais put at risk in forex less than 0.5% of their assets. This would mean they could handle two hundred dramatic losses of 100% each before bankrupcy.
Therefore, is a "skewed trading system" one which lacks a sound money management strategy?
AM
1st the arbitrage prices tend to move apart and then start a Coalition Course
lets say 90% of the time what about the remain 10%? where are the limits ?
So the question here is when they arbitrage they use price action stop?
Or “enough is enough” capital loss.
Price action is not realistic because a turn can happens from where ever, so the only remain solution:
“enough is enough” 0.5%, 0.3% depend on your appetite
2nd 0.3% - 0.5% is the amount that most pro traders put in risk
But when you get 10000$ in your account and you want to be reach up to the next month
and start arbitraging or averaging with 5-10% of your account then I am not sure that you will still trading after the end of this month
That is what I try to explain in this forum, that trading is business and you must treat it such.
Think that way!! the old day traders use to putt money in they pockets and going to the
market start dealing but they never take all the money they get, only part of it
I recomend to read Jesse Lauriston Livermore the father of the markets!!
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from a traders point of view !
Imagine a speculative trading strategy that is guaranteed to make money 98% of the time.
Are you interested? There are many ways to accomplish this. Here is a stylized example:
You draw a card from a 52 card deck. If it comes up any card other than the ace of
spades, you earn a million dollars. If it comes up the ace of spades, you lose 52 million
dollars. On average, you will lose just over $19,000 each time you play, but you will win
51 out of 52 hands. This is what is known as a skewed trading strategy.
Here is a non-stylized example. A client of mine recently hired a new head trader. One
five-minute meeting with the guy was enough to convince me he was a bad apple, but my
stark warnings weren’t enough to curb the client’s enthusiasm for their new hire. The
trader set to work and quickly established himself as a consistent money-maker. Month in
and month out, he earned three million dollars for the client. It was like clockwork. He
was the champion trader—the trader who walked on water. He went around telling
people “I’ze the man!” Less than a year after he joined the firm, it all fell apart. In one
bad month, he lost 30 million dollars. To make matters worse, he tried to cover up the
losses by hiding losing trades in his desk draw, but that is another story. The trader had
been making his money by selling way out-of-the-money options. Month in and month
out, he pocketed three million dollars in premiums, until one month when the markets
moved dramatically against him and the options were exercised. He had been trading a
skewed strategy.
Skewed trading strategies derive their name from the shape of the probability distribution
of the P&Ls they generate. Exhibit 1 indicates the shape of the distribution for the P&L
of a non-skewed trading strategy. It is symmetric. Absent a competitive advantage or
disadvantage, this strategy will, on average, break even before financing and transaction
costs. This means that the distribution will have an expected P&L of zero. Fifty percent
of the time the strategy makes money. Fifty percent of the time it loses money.
Exhibit 1: A non-skewed trading strategy has an equal probability of
outperforming or under performing its expected P&L.
While the actual shape of the P&L distribution of a skewed trading strategy depends upon
the particular strategy and the length of time over which P&Ls are calculated, they all are
skewed. Exhibit 2 illustrates such a P&L distribution. Again, absent a competitive
advantage or disadvantage, the strategy will break even on average. Its expected P&L is
zero. However, because of the negatively skewed distribution, there is now a high
probability of making a little money and a low probability of losing a lot. Overall, there is
a sixty percent probability of making money and a forty percent probability of losing
money.
Exhibit 2: A negatively skewed trading strategy may have the same expected
P&L as a non-skewed strategy, but it has a higher probability of outperforming its
expected P&L. This is offset by a small probability of suffering a significant loss.
Those probabilities can be made more extreme by increasing the skewness of the
distribution. How do you do that? The answer depends upon your particular trading
strategy. If you are selling out-of-the-money options, sell options with even further outof-
the-money strikes.
There is an old saying on trading floors:
Watch the trader who makes consistent money. He is the one who is going to
blow up.
Hedge funds are a category of investors that make consistent money. They also have a
noticeable tendency to blow up. Long Term Capital Management (LTCM) is the obvious
example, but there have been others … the Granite Fund, Fenchurch Capital Management
and the Manhattan Fund.
Many of the trading strategies—statistical arbitrage, convergence trades, risk arbitrage—
that hedge funds employ are negatively skewed strategies. Here is an example. A trader
tracks over time the credit spreads of a large set of bonds. When a bond’s spread widens,
the trader buys the bond. He waits for the spread to return to its historical levels, sells the
bond, and pockets a profit. It works like a charm, except occasionally the spread
continues to widen, and the trader is left holding a distressed bond.
When a bond’s spread widens, this usually means something has happened to cause
investors concern about the issuer. Most of the time, those concerns aren’t realized, and
the spread returns to its past levels. Occasionally, the concerns prove all too valid, and the
spread continues to widen. In this sense, statistical arbitrage is like selling far out-of-the
money options. It makes consistent money, but occasionally realizes a dramatic loss. It is
a negatively skewed trading strategy.
Do hedge funds add value? No one is sure. Their returns are so dominated by the
skewness in their trading strategies that it is impossible to tell. I suspect that, after the
managers have subtracted their management fees, investors are taking a bath. Of course,
this can be true only on average. Investors in hedge funds that don’t blow up often make
money. Investors in hedge funds that do blow up lose their shirts.
Value-at-risk (VaR) is the standard tool for assessing market risk in trading portfolios.
Most implementations are poorly equipped to warn of skewed trading strategies.
Depending upon the specific trading strategy and the specific VaR implementation, your
VaR measure may or may not recognize what is going on. If a trader is selling far out-ofthe-
money options, a Monte Carlo or quadratic VaR measure will recognize this. Either
type of VaR system can be modified to report the (mathematical) skewness of a trader’s
P&L distribution along with the usual measure of his VaR. The more negative that
skewness number, the more you should be concerned.
Most VaR systems cannot recognize skewness arising from other trading strategies, such
as statistical arbitrage. They do not incorporate a sufficiently sophisticated model of
relative price dynamics to do so. The solution is to be aware of what trading strategies are
skewed and closely monitor traders to see how much they rely on those strategies.
If you have a trader walking around saying “I’ze the man,” it may be too late.