3SOF

David and Ramsburg have written of the possibility of creating a Hedge Fund one day, and I thought it would be useful to start discussing some of the strategies and techniques of what some Hedge Funds often do to generate their amazing returns. By creating this topic, and maybe its own board someday, it is my hope that the Stocks on Fire community could gain the belief and understanding that Hedge Funds are not just something for others to benefit from, and realize that their techniques are not that much more different or superior to some of the topics already discussed here. I hope some of you, members or not, find this discussion of value.
Although the classic term "hedge" has changed greatly from what we have commonly thought it to be - IE: buying both long and short of a security, and holding until both values intersect, it is important to realize that their techniques are constanting evolving to seek profits from new inefficiencies of markets. The most important and common characteristic of Hedge Funds is that their assets are spread out over many uncorrelated strategies or systems, insuring that the overall performance of the fund is not too greatly inter-dependant of any "one" approach. In James Altucher's book, "Trade Like a Hedge Fund," he writes that, "No system is the Holy Grail for the markets, in the same way that no investor should bet on one stock to blase his or her way to riches. Just like the buy and hold stock investor, the hedge fund trader relies on diversification, only a hedge fund's diversification is of uncorrelated systems, rather than diversification of uncorrelated stocks" (p. xii). To begin what I hope becomes a lengthly discussion, I would first like to write about the 20 techniques Altucher commonly uses to generate profits. Although there are many more sophisticated books at your neighborhood bookstore and I welcome any comments on those, Altucher speaks in a straight forward language that's easliy understood for anyone intimidated by hedging talk. Maybe, after I receive my PHD in physics from Eaton, we can discuss quantitative economic theories over some tea in Geneva, Switzerland, but I doubt it.

The following is a list of the twenty chapters of James Altucher's "Trade Like A Hedge Fund," each one discusses one technique of hedging, and the various ways to use that technique. In as few words as possible, I would like to create a post describing each chapter/technique, however, I strongly urge readers to buy the book to receive the best possible instructions of employing these various strategies and reviewing the impressive tables and graphs of Altucher's performance with each.

Technique 1: The Bread and Butter - Playing Gaps

Technique 2: How to Play the QQQ - SPY Spread Using Unilateral Pairs Trading

Technique 3: Buying Bankruptcies

Technique 4: Using the Tick

Technique 5: Playing the Bands

Technique 6: Stocks Less Than $5

Technique 7: The Slow Turtle

Technique 8: The QQQ Crash System

Technique 9: The Relative Fed Model (and Other Fun Things You Can Do with Yields)

Technique 10: Deletions from the Indexes

Technique 11: Everything You Wanted to Know About the 200-Day Moving Average but Were Afraid to Ask

Technique 12: End of Quarter, End of Month, Outside Month

Technique 13: Ten Percent Down - Panic 101

Technique 14: Taking Advantage of Option Expiration Day

Technique 15: Extreme Convertible Arbitrage

Technique 16: Intraday Bollinger Bands

Technique 17: All Good Things Come in Fours ("4" Is a Magic Number)

Technique 18: The Wednesday Reversal

Technique 19: What Does Not Work?

Technique 20: Reading List

One Note: Please be patient for my posts. They will come, but other demands (my portfolio, kids & wife - in that order), require me to strictly balance my time to this endeavor.

Brief Intro - A couple of things that Altucher recommendeds to begin are to read "Practical Speculation" by Victor Niederhoffer and Laurel Kenner, and to purchase the simulation software package called "Wealth Lab." The software can be found at www.wealth-lab.com, however, my research has discovered that it is only available, for around $700, for those outside the US, US residents must be a customer of Fidelity Financial. I will make more inquires about this, but if anyone finds out more information please feel free to post it.

Technique #1 - Much has been written about "fading the gap" by EliteG and Aussie on Stocks on Fire, and like they said- some traders only play gaps. They look for stocks that are gapping up or down, and then fade them back to the prior day's close.  Shorting gap ups, or going long on the stocks that gap down is the general strategy, however, not all gaps close. Altucher describes the basic approach in the following example:

System#1  Filling the Gap

-Buy a stock when it opens more than 2% lower than the prior close
-Sell at yesterday's closing price or at the close if yesterday's closing price never hits.

Altucher ran this test on all NASDAQ 100 stocks (including deletions) using a 100,000, and his results from January 1, 1999 to June 30, 2003 only produced a .58% average return from 9821 trades.

However, Altucher describes how this system gets a modest boost if the day before is down, possibly because short-sellers would already be modestly in the money and then the further gap down gives them an additional profit that they might, at that point, want to take.

System #2

-The Rules for system #2 are the same for system #1 except only buy when not only is there a 2% gap down or greater, but also when the day before was a down day for the stock.

Using this system the average return increases from .58% to .75%. Still, the return is not significant if you take into account commissions and slippage, which could be as high as .40% per trade or more. For this, Altucher suggests looking for a 5% gap down.

System #3

-Buy a stock if the stock was down the day before and if the stock is opening 5% lower than the close the day before.
-Sell either if the stock hits the close of the day before or if the stock closes without hitting the profit target.

Here, we can begin to see results of a system that might be worth playing. Of 993 trades, the average return is 1.97%. Although this is an improvement, Altucher suggest making one more tweak to the test to make it significantly profitable. What happens when the market as a whole is gapping down?

System #4

-Buy a stock if the stock was down the day before, if the stock is opening 5% percent lower than the close, and if the QQQ is also gapping down at least one-half percent.
-Sell if the gap is filled or at the end of the day.

Starting with $1,000,000 and using 100,000 per trade from March 10, 1999 to January 1, 2003, Altucher shows (in Table 1.4) the average return of 2.07% on 525 trades. For his portfolio, using only this system on all NASDAQ 100 stocks (including deletions) within this time frame, the net profit was $1,593,543. That results in an average annual return of 28.32% with a Sharpe ratio of 1.29%.

I suspect Altucher is not big on shorting stocks (neither am I), but he briefly describes one for gaps here.

System #5

-Short a stock when the stock is up the day before, the QQQ are gapping up at least one-half percent, and the stock is gapping up greater than 5%.
-Cover when the stock closes the gap(cover at the closing price of the day before) or close the position at the end of the day.

Here the results are not great, producing an average return of -.56%. Altucher writes, "Even in a bear market, shorting too much exuberance (sometimes referred to as "irrational) has not paid off for the speculator.

***But, my favorite gap play is "Swing Trading the Gap." Altucher shows how gap-fill trades do not have to be closed out just because the gap is filled. In fact, it is better to hold on to them and try to press for as much as possible. If we take System #4 and add a simple step that allows us to hold overnight (holding overnight can contain many risks and being in cash allows one to sleep better), we can drastically increase the profitability of the system.

System #6

-Buy a stock when the stock is down the day before, QQQ is gapping down more than a half percent, and the stock is gapping down more than 5%.
-Hold the stock at least until the next morning
-Sell when the stock goes lower than the prior day's close..

This test, performed with the same size portfolio and amount per trade, resulted in an average return of 3.64%. Altucher's net profit on a starting portfolio of $1,000,000 was $3,726,416 during the worst bear market in NASDAQ history.
Not too shaby.

Great read Tommy, thanks for posting. Applaud

First, let me say "don't be intimated by the name of this technique."

The best way to begin is by describing what "pairs trading" is. Altucher puts it this way, "Pairs trading usually implies a market neutral strategy where you go long one asset and short another asset." When looking closely at market activity, it is easy to spot two stocks that generally move together. One example is Ford (F) and General Motors (GM). Although these two are not equal in value, historically they can be view as a pair because they follow each other's moves, therefore they are correlated. However, when one of the pair moves out of step with the other, Hedge Funds can step in and buy long, or sell short, or take both positions to expolit the inefficiency. "While pairs trading at first glance seems safer than directional trading where one takes a bias in the market, up or down, and bets on that bias, the reality is that pairs trading can be much less safe than other forms of trading. A common slogan used to refer to this pairs trading is: 'twice the risk and half the gain,' and that largely true" (23).

A good example of such risk could of been witnessed most recently in early summer when GM's stock had not moved down sufficiently to that of Ford's. Many Hedge Funds were caught off guard, when they shorted GM shares to profit from the historic norm of the two automakers, by activist investor Kirk Kerkorian's offer to purchase up to 10% of GM's shares at a premium. This caused GM stock to pop and forced a short squeeze of many Hedgers. Although this one example didn't work out for the Hedge Funds, many times it does, and it is commonly referred to as "betting on a mean reversion of the spread" (23). More can be learned of Pairs Trading from specific books addressing this technique and by websites, such as  www.pairtrader.com

However, our technique is Unilateral Pairs, and Altucher describes it as, "we are going to take just one side of the pair" (23). The "difference in using unilateral pairs trading is that we will not trade both sides of the spread, but only the side that is historically more volatile" (24). The idea is that the more volatile side is most often the culprit for why the spread has gone awry.

For this technique Altucher uses the calculated spread between the QQQ and the SPY pair (the spread is referred to in increments called deviations), but he only trades the QQQ.

To Find the Spread (this system is complicated and requires coding in Wealth Lab, and the code is provided in the appendix of this technique in the book):

1. Calculate the ratio of the QQQ price series over the SPY price series. For example, on May 1, 2003, SPY was 91.92 and QQQ was 27.42. The ratio for that day was 27.42/91.92, or 0.298.

2. Calculate the 20 day moving average of that ratio.

3. For each day, calculate the difference between the ratio and its moving average.

4. Calculate the 20 day moving average of those differences.

5. For each day, calculate how many standard deviations the difference in ratios is for that day from its moving average. Calculate the standard deviation for each day using its prior 20 days.

6. For each day, if the standard deviation calculated is greater than 1.5 and the QQQ is 2% greater than the prior day, then short QQQ. (In other words, the spread between QQQ and SPY has become much greater than usual. If this is true and QQQ had a big move up, then QQQ is most likely the culpritand needs to be shorted).

7. For each day, if the standard deviation calculated is less than -1.5 and the QQQ is 2% lower than the prior day, then buy QQQ

8. Sell/Cover when the standard deviation of the difference in the ratios is less than .05(in the case of the short) or greater than -0.5(in case of the long).

**Don't get discouraged. This is only Altucher's method of calculating the spread between QQQ and SPY. You may come up with a simpler way to quantify this after studying the QQQ and SPY closely. The point is that QQQ and SPY are a pair, and Altucher chooses to only trade in QQQ because it is the more volatile of the pair.

Perhaps an example would help:

On May 23, 2003, QQQ fell almost 3.6% and SPY fell 2.3%, a larger than usual ratio of percentage changes between the two exchange traded funds, specifically more than 2 standard deviations away from the average difference between the ratio between the two assets and the 20 day moving average of that ratio. Altucher's system bought QQQ at the next open at 27.76 and held until the number of standard deviations between the ratio and its moving average goes back above -0.5 standard deviations, which occurs on May 28. The system sells at 29.16 for a 5.04% profit (p.27).

Altucher ran a simulation on QQQ using the unilateral pairs trading system starting with $1 million dollars and using 100% of equity per trade (Wow!), and he came up with 72% success with an average return of 2.72% (If you don't think that's impressive you don't understand the power of compounding). From March, 1999, to January 2003, this technique turned 1,000,000 into 5,621,253 with making just 72 trades (p.28). Again, it is important to point out that this performance was during the worst bear market in NASDAQ history.


Altucher continues by stating "this system will work on any two assets that are highly correlated where one asset is more volatile than the other. For instance, SMH, which is the EFT for tracking the semiconductor sector, is correlated with QQQ(all of the components of SMH are also components of QQQ) and has been more volatile since its inception on June 5, 2000. Using QQQ as the other member of the pair but only trading SMH (because it is more volatile) according to the rules previously stated, would have produced an average profit of 3.90% with 38 trades over the same time period (p.38).

"Similar results can be found between stocks and their peers. For instance, KLAC and NVLS are two components of the Philadelphia Semiconductor Index (the SOX), making up 12% and 9% respectively. Viewing KLAC and NVLS as a pair but trading KLAC according to the rules previously specified has shown an average profit of 2.84%."

Here, an extreme example occurred on April 10, 2001, when "KLAC fell over 25% and NVLS fell about 20%. The average spread between these two highly correlated stocks fell about 2 standard deviations from its norm, and KLAC had a greater than 2% down day on April 9th, so all the conditions were in place. Buying KLAC on April 10 at 34.45 and holding until the standard deviation of the spread fell back below 0.5 standard deviations would have resulted in a profit of 54.28% when the system sold on April 20 at 53.15 (p.40).

Altucher also shows how ALTR and XLNX make another good pair of highly correlated stocks, with ALTR being the more volatile of the two. "Using these two as the pair, and ALTR as the trading vehicle we get an average profit of 4.09% with 56 trades over the same time period (p.42).

In conclusion, though there are more than enough opprotunities to find highly correlated pairs and map out the spreads between the pairs, most of these strategies are becoming too crowded and the spread are becoming too thin to expolit the inefficiency. However, Altucher believes, by choosing to focus on this strategy of Unilateral Pairs Trading, and "mapping out correlations between highly liquid and highly correlated instruments such as QQQ and SPY, SMH and QQQ, KLAC and NVLS, and others, you can find opprotunities that will arise in the spreads between these assets, regardless of market condition (p.42).

This stuff is really cool. *Applaud* Thanks for posting and keep up the good work!

tommyt:

Good work. I have made a copy of your posts and will
spend some time to study the systems.

Big applaud.