2008 Jun 16 - Mon

Mean Reversion Thoughts

While still putting together the code for a trading solution, I've been thinking about what algorithms to implement for a trading strategy. I have access to live intra-day tick and quote data, so mean-reversion aka contrarian strategies seem like interesting candidates.

In the course of manual trading, I've learned that one needs to keep track of a number of items: current portfolio costs, current holding costs, existing profit/losses, expected market direction, current market location, external influences. This is a lot to do manually. Hence the desire to implment tools to automate, or even semi-automate the process.

A paper by Subramanian Ramamoorthy called A strategy for stock trading based on multiple models and trading rules discusses a state space mechanism for determining how to manage the portfolio composition. Another item he brings to the foreground is a description of the Sharpe Ratio, a ratio which helps one to keep profit consistent rather than widely dynamic.

Using different terminology, the makers of NeoTicker have a blog with an article called Counter-Trend Trading with Simple Range Exhaustion System. The key point, which could be hard to do, is "most counter-trend traders will try to time their entries as close to the extreme reversal points as possible to maximize the profits and minimize the risk exposures". Using multiple time frame charts, and reading the tape, along with some possibly helpful technical analysis tools, it might be possible to home in on the zones of reversal.

Working my way into a little scalping in the futures, an older article at Interactive Brokers explains the birth of the Dow Mini Futures. Some interesting points:

• "try to identify the leader in a group and how its price movement can help us predict movement in others in the group"
• "we start to trade it by hand so we can get a better understanding of the nuances in that particular trade"
• "We have a trader and a programmer trade together for a while and then we start the process of automation. We define our risk parameters and write the rules that we feel give us an opportunity to be profitable."
• "In our back testing we saw that if we were patient it would be profitable for us. The hard part was learning to be patient because our other successful trades were very high frequency. In the mini-sized Dow we may be in and out of 5 to 10 trades in a less than minute."
• hedge the mini dow with the underlying basket of stocks
• "We don't have scalping targets. We generate a theoretical value and make markets based purely on that value If we our pricing is accurate and we should naturally be able to scalp."
• "In the Dow because the bid-ask spread is so tight most of our profits are generated from trading."
• "he dow has a much tighter spread compared to the mini-spu. Also it is much easier to watch the stocks in the underlying basket to ascertain their effect on the future."
• "The Russell tends to be trendier than other indices."