# Leveraged Trading 2 – Trading Systems

Today’s post is our second visit to a new book by Rob Carver, one of our favourite financial authors. The book is called Leveraged Trading.

Contents

###### Trading Systems

In Chapter Three, Rob introduces us to trading systems.

He says that a trading system has three jobs:^{1}

- When to open a new position
- This usually means buy, but would mean sell for a short.

- Deciding the size of the position
- This is to do with risk and money management

- When to close a position (its duration)
- Usually, this means to sell, but with shorts, it means to buyback
- Selling is harder for humans than buying is

Rob summarises the advantages of using a system:

- It will allow you to overcome human emotional and behavioural biases.
- Put simply, systems make better forecasts than humans.

- Systems can also exploit these biases in others.
- Systems will have been back-tested against historical data.
- The same rules can be applied to many instruments, allowing for easy diversification.
- And systems can be automated if you so desire.

He also runs through the common objections to using a system, but most of them don’t hold water.

One valid criticism is that systems can’t adapt when markets change.

- Rob’s solution is to use systems whose source of return has persisted for a very long time.

It’s also true that systematic investing is boring (if you are doing it properly).

- But investment isn’t supposed to be fun – it’s meant to be profitable.

Rob also warns against trading systems from “expert advisers”.

- And against copy trading, because the websites involved use poor scoring methods that can be easily gamed.

###### Trading concepts

In Chapter Four, Rob explains some basic trading concepts.

Here’s what you need to be familiar with:

- An instrument or product – dated or undated
- A trading rule, including position sizing and stop-loss rules
- Capital
- Home currency and instrument currency
- Standard deviation and gaussian normal distribution
- Note that annual SDs are 16 times the daily SD
- The S&P 500 has an annual SD of 16%, and a daikly SD of 1%

- Annual risk = (notional) exposure * annual SD
- Risk-adjusted returns, as measured by the Sharpe ratio
- Risk targets, measured as an annual SD
- Minimum trade size and incremental trade size, the minimum required capital
- Risk-adjusted costs (RAC) – costs as a proportion of your risk target
- For example, 1.5% costs with a risk target of 15% equals 10% RAC
- This measure of costs is unaffected by leverage
- It also shows how much your SR will be reduced by – 10% RAC will reduce your SR by 0.10

- Annual costs, from holding costs and transaction costs
- Risk-adjusted holding cost = holding cost / instrument risk
- This measure is unaffected by leverage
- Risk-adjusted per transaction cost = transaction cost / instrument risk
- Risk-adjusted annual transaction cost = transaction cost/instrument risk * number of trades per year
- Total RAC = RA annual transaction costs + RA holding costs

###### The Starter System

Chapter Five introduces Rob’s Starter System (we’ll abbreviate this to RSS for obvious reasons).

The RSS:

- trades a single instrument via a single product
- uses one rule to open a position
- a second rule to calculate the size of the position
- and a third rule to decide when to close a position

To decide which instrument to trade, Rob works out the SR for a wide range of instruments using the RSS.

- The average SR is 0.24, but there is a wide spread (from 1.5 to -0.5)
- The best SRs are shown by Italian and French bonds.

But when the one- and two-SD error bars are added to the plot, it’s clear that it’s impossible to say with any certainty which instruments have performed better than others.

- There just isn’t enough data to decide.

Rob recommends ignoring pre-cost returns when deciding which instrument to trade.

###### Costs

The correct approach is to use the instrument and products with the lowest costs.

- Unfortunately, these often require the most capital, and so are not available to all traders.

Rob limits his costs to one-third of his expected returns.

- This acts as a speed limit on trading.

When expressed in risk-adjusted terms, this means that the “speed limit” is equal to one-third of the SR.

- The RSS has an SR of 0.24, so risk-adjusted costs (RAC) should be no more than 0.08, or 8%.

In practice, Rob aims for 5% – but he uses relatively cheap futures.

- These have a RAC of 1%, but require £40K of capital.

DFB spread bets require only £2.6K of capital, but cost 11%.

- Quarterly spread bets (and those on FX or index futures) between 2% and 6% (lower than the speed limit).

Undated products are more expensive than their dated equivalents.

###### Tax

Rob plays down the significance of tax to most traders.

- The RSS is only expected to make 5% a year, and we each have an annual CGT allowance of 12K.

So you would need to be trading £250K to run into problems.

- If that’s the case, you might prefer to use spread bets.

Rob calculates the break even point where spread bets beat cheaper (but taxable) futures as being £340K.

###### Opening

Rob likes trading rules to be:

- objective
- simple
- explainable
- to provide intuitive signals
- and of course, to have a profitable back-test

The RSS uses a momentum rule – a moving average crossover.

- Note that this rule can also be used to close positions.

The values of the fast and slow MAs are chosen not only according to returns.

- Rob also wants to target a given amount of trading each year.

He uses a fixed ratio of 4 between fast and slow (eg. 16 days and 64 days) to investigate.

- My favourite pair is 50 and 200, which also has a ratio of 4.

Rob says that any ratio between 2 and 6 is fine.

- Rob’s analysis shows that 64/256 produces the best SR, but anything from 8/32 upwards is fine.

Faster crossovers lead to more trades and higher costs.

- 8/32 is the fastest pair with costs below the speed limit.
- 8/32 generates 9 trades a year on average.

Rob chooses 16/64 as the pair he will use.

- This generates 5.4 trades per year on average.

For many instruments, longer pairs will have a performance too similar to buy-and-hold.

- Very volatile stocks might be the exception to this.

Rob also feels that the excessive boredom produced by rules that lead to very few trades can lead to problems.

###### Position sizing

Position sizing is a two-stage process:

- Work out your target exposure (in £)
- Translate that to units of your chosen instrument/product.

Target exposure = target risk % * capital / instrument risk

So if you have £10K in your account and a 12% risk target, in order to trade the S%P 500, which has a 16% annual risk, the calculation is:

Exposure = 12% * 10,000 / 16% = £7,500

This translates to a leverage factor of 0.75 (£7.5K / £10K).

###### Risk targets

Rob also calculates a maximum prudent risk target by looking at maximum losses.

The S&P once crashed 25% in a day (October 1987).

- If your maximum bearable loss is 33.3%, then the prudent leverage is 33.3%/25% = 1.33

So your maximum prudent risk target is 1.333 * 16% (S&P annual risk) = 21.3%

Rob recommends a risk target for the RSS of 12%.

- At 24%, you have a 1 in 4 chance of an annual 10% loss, and a 1 in 6 chance of an annual 20% loss.

Rob himself uses a 24% target, based on his personal appetite for risk.

- This is also the optimal risk target from the Kelly analysis, given that the RSS has an SR of 0.24.
- Which means that a 24% target would make the most money in the long run.

But most traders use a conservative target of “half-Kelly”.

- This takes into account uncertainty and trading costs.

And gets us back to a 12% risk target.

- Rob notes that most hedge funds target between 10% and 20% risk and their systems are much better than the RSS.

###### Conclusions

We’ll leave it there for today.

- We’ve covered another one-sixth of the book, so we’re still on track to finish in another four articles (plus a summary).

The pace picked up today, and we’re into the meat of the basic system.

- In the next article, we’ll finish off the system rules, and take a look at how it trades.

Until next time.

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- He actually said two, but I think three is a better fit [↩]