One of the best things about this text is that each strategy or technique is treated in quantitative terms.  Even perennial bromides about being long when stocks are above the 200-day moving average or about not using tight stops are presented in light of the real edge they offer in concrete terms. Many of the strategies explained here have been covered previously on the TradingMarkets site, so some material may be familiar.

The chapter titles effectively convey the principles covered:

1 – Introduction
2 – Think Differently; Rule 1- Buy Bullbacks, Not Breakouts
3 – Rule 2- Buy the Market After It’s Dropped; Not After It’s Risen
4 – Rule 3- Buy Stocks Above Their 200-Day Moving Average, Not Below
5 – Rule 4- Use the VIX to Your Advantage… Buy the Fear, Sell the Greed
6 – Rule 5- Stops Hurt
7 – Rule 6- It Pays to Hold Positions Overnight
8 – Trading with Intra-day Drops – Making Edges Even Bigger
9 – The 2-Period RSI – The Trader’s Holy Grail of Indicators?
10 – Double 7′s Strategy
11 – The End of the Month Strategy
12 – 5 Strategies to Time the Market
13 – Exit Strategies
14 – The Mind
15 – The Finale

Of these, the chapter advocating against the use of stops is probably the one most likely to meet with resistance: practically, because it is psychologically difficult to watch a large loss get even larger, and theoretically, because abandoning stops seems likely to increase the variance of returns for a given strategy.

One feature we noticed is that the majority of the techniques explained in Short Term Trading Strategies That Work rely on mean reverting tendencies to generate a trading edge.  Some examples: the Relative Strength Index (RSI) is widely used as an indicator of “overbought” and “oversold” market conditions, where the “over” implies that an underlying has moved too far too quickly and is likely to revert in the direction of a recent mean.  The “Double 7′s Strategy” likewise takes contrarian positions when an underlying closes at a 7-day high or low.  So, mean reversion plays a big role in this book, and that’s not a criticism (cf. our “Using Options to Trade Mean Reversion“).  Still, we would caution traders to keep an eye on the behavior of the markets in general: mean reversion, after all, has not always been quite such a forceful tendency, and contrarian strategies are bound to underperform during markets characterized by momentum trading.

Michael over at Marketsci has been testing some of these trading rules, with largely positive results, so be sure to check out that series.

And you can read a sample chapter from the book here.

Do mean-reversion bets on breakouts/breakdowns beyond the post-expiration weekly range provide any discernible edge?

Member Tom D. raised the question that got us interested, and he put it this way:

At the end of the first week of an option period, mark the high and low of that first week’s trading. Wait for price to exit that range either up or down. Then trade for price to return to, or at least make a large move toward, that first week’s range before the end of the option period. [...] My fantasy about all of this was the following. As the market moves further from the range, idiot momentum players are buying calls if the move is above the range, and fearful hedgers are buying puts if the move is below the range. And the sellers of options are happy to oblige because those sellers, being the stronger hands, know that they and their friends can move the market back toward the range prior to expiration.

Does it work every time? No. And when it works, it sometimes produces a small return. But I recall concluding back in the early 1990′s that there was a 100% probability that the price range would be exceeded one way or the other sometime during the option period and that there was an 80% probability that price would return to the range prior to expiration.

Anything to this?

Parameters

Just to clarify, the rules of the strategy we’re testing are: mark the high and low of the range for the first week after options expiration.  On the first close above (below) that range, sell (buy) the underlying in the expectation that it will revert to the mean, or at least back to within that range.  Exit two days before expiration to avoid gamma-fueled surprises.

Since the intent here is to sell the OTM options that get a little more expensive on the breakout, you would sell call spreads or put spreads when the system signals a trade and ignore subsequent trades, allowing those spreads to decay.  But there’s nothing to prevent you from playing both sides, so we decided to allow multiple entries in a single month, meaning that if, for example, the price broke below the range and then traded back into and then above the range, we’d have two trades there, a long entry and then a short, or a short put vertical and then a short call vertical if you’re playing this with options.  In our test, most of the time only one entry was signaled, and a quick look suggests that any second signals were basically a wash.

Results

As you can see, this post-expiration range reversion strategy has outperformed a buy-and-hold S&P 500 approach over the past 15 years.  It missed out on the late-90s tech bubble, tracked the early-00s real estate/commodity bubble pretty closely, and has dodged the worst of the worst in 2007-8, recovering promptly after a major drawdown last month.  With a profit factor (gross profit divided by gross loss) of 1.45, this system looks pretty attractive given that it is in the market less than half the time.  [All results reported do not include transaction costs, dividends, or interest earned.]

General Mean Reversion

But let’s dig a little deeper: one possible objection would be that mean reversion is typical of the market in general, and that any edge obtained above is due to this general characteristic, rather than to any specific feature of the week after expiration.

Initially, that objection seems misplaced: we tested two similar systems to see whether that first week after expiration offers any special edge.  In the chart below, “Exp Wk Reversion” is the primary strategy as described above, “Any Wk Reversion” trades the same strategy using a one-week lookback that is agnostic about the last expiration but still holds to the next one, and “Non-exp Wk Reversion” trades the same strategy using a one-week lookback but excludes signals generated based on the first week after expiration.

Results are initially encouraging: the non-expiration system seriously underperformed our primary strategy, with a lower profit factor and an inferior equity curve.

Conclusion

However, the combined “any week” approach performed best of all – again in terms of both relative profitability and absolute return – which suggests to us that the most important variable in mean reversion trades of this type is likely not the entry condition itself, but the amount of time that is allowed for mean reversion tendencies to kick in.  If there really was any edge to a first week-only approach, we would expect the any-week equity curve to drift somewhere between the other two, instead of outperforming significantly.

As to the hypothesis about momentum traders overreacting to post-expiration breakouts/breakdowns and providing nice opportunities for these contrarian plays: that hypothesis could be a consistent occurrence in the market and yet be easily overwhelmed by other more potent forces.  And in the absence of any discernible edge from trading breakouts of the week after expiration versus other weeks, we don’t see much justification for accepting the hypothesis.

The silver lining, though, is that all three contrarian systems easily outperformed the benchmark over the past 15 years, which leaves us wondering why anyone still has money parked in any long-only index funds.

[Photo courtesy of Flickr user matthewfch.]

2) Entrepreneurial Idea-Generators – The research found that one of the two trait facets associated with financial risk assumption was “ideas”. The entrepreneurial trader is one who derives particular interest and satisfaction from idea generation (developing views on markets, building trading systems) and, out of a commitment to those ideas, is willing to assume risk. We would expect these participants to be more disciplined and, to the degree that they are actually skilled in their idea-building, more successful in their trading and investment outcomes.

[...]

This distinction between the “gambler” and the “entrepreneur” helps explain why the capacity for risk-taking is associated both with great blowups and with great career success among traders and portfolio managers.

There are at least three personalities discussed in this post: the gambler, who takes on risk in an undisciplined way for the pure stimulation of it; the depressive, who lacks the optimism and creativity to generate and pursue new ideas, and the entrepreneur, who is able to generate novel strategies but is also disciplined enough to carry them out successfully.

Beta vs Alpha vs Human Nature

Recall that, in finance, beta refers to the correlation between the returns of a given strategy or portfolio and the returns of the market as a whole.  A portfolio with a beta of one will move in step with the market.  A beta of zero indicates that the portfolio’s returns are independent, while a beta above 1 indicates that the portfolio is actually more volatile than the market.  Beta is easy to achieve: any broad index fund will have a beta of 1, or something close enough.

Alpha, by contrast, refers to the excess return of a given strategy or portfolio as measured against its benchmark.  Their claim to be able to generate significant alpha – that is, to produce returns far in excess of what the market naturally achieves – is the justification that drove so many investors into the arms of hedge funds.  Alpha is just one of several ways to measure risk-adjusted returns – r-squared and Sharpe ratios are also important – and they all help determine whether a strategy or portfolio is achieving the goal of returns in excess of and independent from the market average.

But consistently generating new ideas is hard.  This is the fact that Steenbarger is honing in on.  There will never be a shortage of traders who dazzle themselves with the speed and intensity of market action, and who don’t hesitate to take on enough risk to make even the Lehman risk management desk blush.  It is easy to be undisciplined, emotion-driven, and to depend on the stimulation of winning and losing (painful losses, after all, do provide a unique sort of stimulation; de Sade was on to something).   And, of course, the alternative to undisciplined risk taking is usually just disciplined avoidance of risk – dumping it all into index funds and walking away, for instance.  That’s a reasonable approach for most investors, but it’s not a successful approach to trading, unless you define success as “beta=1, r-squared=100.”

So the three personalities seem to break down like this:

• gambler: undisciplined risk-taking
• entrepreneur: disciplined risk-taking
• depressive: disciplined risk-avoidance

The disciplined risk-taker is clearly the optimal type.  Where do such personality traits come from?

MBA or PhD?

We wonder whether the “entrepreneur” label is the best one.  This is a tiny point, barely worth mentioning, but the kind of education offered in most business programs today seems to offer very thin coverage of the kinds of reasoning skills that make idea-generation (of the sort Steenbarger is talking about) possible.  Friends who soldiered through M.B.A. programs have reported more conformity than creativity, and we wonder whether most putatively entrepreneurial graduates aren’t, in truth, merely the franchisees of other people’s ideas.

Critical thinking can be taught; intellectual discipline can be inculcated.  But any profit-driven educational program will have disincentives to produce students who can think independently.  After all, corporate America requires a steady diet of workers who can do only one or two things, but can do them well – and this seems to be true also in all but the highest levels of medicine and law.  In contrast, the arts & sciences, to the extent they still have any independence from market forces, have a mandate for the formation of persons that reaches farther than the professions, toward seemingly archaic concepts like truth and justice and beauty.

Of course, “entrepreneur” doesn’t necessarily refer to someone with one or more degrees in business.  Some entrepreneurs are just naturals.  But for those of us not blessed with innate genius and creative power, education is necessary, and the best education for success in trading may well come from programs other than business and finance.