In a post some years ago, I argued that leveraged ETF (especially the triple leveraged ones) are unsuitable for long-term holdings. Today, I want to present research that suggests leveraged ETF can be very suitable for short-term trading.
The research in question was just published by Prof. Pauline Shum and her collaborators at York University. Here is the simplest version of the strategy: if a stock market index has experienced a return >= 2% since the previous day's close up to the current time at 2:15pm ET, then buy this index (via its futures, ETFs, or stock components) right away, and exit at the close with a market-on-close order. Vice versa if the return is <= -2%. The annualized average return from June 2006 to July 2011 was found to be higher than 100%.
Now this strategy is actually quite well-known among institutional traders, although this is the first time I see the backtest results published. The reason why it works is also quite well-known: it has to do with the fact that every leveraged ETF need to rebalance at the market close in order to keep its leverage constant (at x2 or x3, depending on the fund). If the market index goes up, the fund needs to buy the component stocks; otherwise, it needs to sell stocks. If there is major market movement (with absolute return >= 2%) since the previous close, then the amount of stocks that need to be bought or sold will be correspondingly larger, resulting in momentum in all those stocks near the close. This strategy aims to front-run this rebalancing to take advantage of the anticipated momentum.
It has been estimated that if the market moves by 1%, the rebalancing could account for up to 16.8% of the market-on-close volume, so the induced momentum can be substantial. Now who is paying for this profits for those momentum traders? Why, the buy-and-hold investors, of course. This loss for the ETFs shows up as their tracking errors, resulting in a cost of as much as 5% per annum for the buy-and-hold investors. Yet another reason we should not be one of those investors!
As Prof. Shum pointed out, if you trade this strategy live today, you will likely get a lower return, because of all those momentum traders who drove up the price way before the close. However, there may be an ameliorating factor at work here: this momentum is proportional to the NAVof the ETFs. As their NAV goes up with time (either due to additional subscriptions or positive market returns), the returns of this strategy should also increase.
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Now for some public service announcements:
1) A company called Level 3 Data Corp sells proprietary data indicating buying and selling pressure on stocks. Their internal backtests show that adding these data to some common stock trading strategies essentially double their returns. An explanatory video is available, and I heard they are offering 3-month free trials.
2) The London Systematic Traders (LST) Club has asked me to say a few words about their new initiative to build a London centric collaborative community of traders, developers and researchers.
LST aims to be at the intersection of traders, developers and quants with a strong emphasis community building and on knowledge exchange, providing a trading networks with a very specific focus on systematic, algorithmic (i.e. automated) or quantitative trading.
Membership is free and open to everybody with an interest in the above topics.
http://www.meetup.com/London-Systematic-Traders/
On Friday, Nov 23, I expect to be hosting a Q&A session with members of the LST (see 2 above) at the Apex Hotel in London. All are welcome. Please visit their website for details.
3) I will be conducting my Backtesting and Statistical Arbitrage workshops in London, Nov 19-22, and look forward to seeing some of our readers there!
Thursday, October 25, 2012
Monday, October 08, 2012
Order flow as a predictor of return
Order flow is signed transaction volume: if an order is executed at the ask price, the incremental order flow is +(order size); if executed at the bid price, it is -(order size). In certain markets where traders can only buy and sell from market makers but not from each other, a positive order flow means that traders are net buyers of a security. But even in markets where everyone can place and fill orders on a common order book, a positive order flow indicates that informed traders (those willing to aggressively get into a position) are eagerly acquiring a security.
The neat thing about order flow is that it has proven to be a good momentum indicator. That is to say, a positive flow predicts a positive future return. This might seem trivially obvious, but you have remember that generally speaking, a positive past return by no means predicts a positive future return. That FX order flow possesses this predictive power was shown by Evans and Lyons in a series of papers, but this indicator is useful in many other markets, and at many different time scales. For example, in a paper by Coval and Stafford, it was shown that if you can tease out the order flow of a stock due to mutual funds' trading alone, you can also predict its future return up to, say, a quarter. This paper not only shows that order flow is predictive, but that sometimes a specific kind of order flow (in this case, that of mutual funds only) is sometimes more predictive than general order flow. In many cases, traders find that by counting only order flow due to institutional traders, or order flow due to large orders, they can better predict future returns. (No wonder institutional traders are trying their darnedest to break up their orders into small chunks, or to trade in dark pools!) I recently also heard that order flow into sector ETFs can be predictive of that sector's return. If any reader has read papers or has experience with this type of sector rotation model, please leave a comment!
Despite the proven usefulness of order flow, not too many retail traders utilize it. The reason is simple: it can be hard to measure. In FX in particular, many markets do not report trade information, or they report with a sufficient delay such that the information has no predictive utility. Even for markets that report instantaneous trade information, you would need a good piece of software to capture every bid, ask, trade, and trade size, and store them in an array, in order to compute order flow, an operation that most retail trading software cannot accomplish. However, this barrier to entry may just mean that there are still decent alpha to be extracted from this indicator.
Now, a bunch of public service announcements ...
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A new algorithmic trading platform called Rizm designed for retail traders is now available. You can sign up for their beta trial here.
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Quantopian has created an event-driven version of my gold/gold-miners arb strategy with source codes and analysis available. I find that the performance metrics clear and useful: better than the output from my own backtest programs! (Quantopian is a platform where you can share backtest results and codes with other traders.)
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Arbmaker is a platform for pair traders, and it incorporates software for cointegration tests, has integrated data feed from many vendors, and allows automated order submission to Interactive Brokers. Neural networks and Kalman filter are also included.
===
Finally, I will be giving a talk titled "Backtesting and Its Pitfalls" at the World MoneyShow at the Metro Toronto Convention Centre on Saturday, October 20. Interested readers can register here.
The neat thing about order flow is that it has proven to be a good momentum indicator. That is to say, a positive flow predicts a positive future return. This might seem trivially obvious, but you have remember that generally speaking, a positive past return by no means predicts a positive future return. That FX order flow possesses this predictive power was shown by Evans and Lyons in a series of papers, but this indicator is useful in many other markets, and at many different time scales. For example, in a paper by Coval and Stafford, it was shown that if you can tease out the order flow of a stock due to mutual funds' trading alone, you can also predict its future return up to, say, a quarter. This paper not only shows that order flow is predictive, but that sometimes a specific kind of order flow (in this case, that of mutual funds only) is sometimes more predictive than general order flow. In many cases, traders find that by counting only order flow due to institutional traders, or order flow due to large orders, they can better predict future returns. (No wonder institutional traders are trying their darnedest to break up their orders into small chunks, or to trade in dark pools!) I recently also heard that order flow into sector ETFs can be predictive of that sector's return. If any reader has read papers or has experience with this type of sector rotation model, please leave a comment!
Despite the proven usefulness of order flow, not too many retail traders utilize it. The reason is simple: it can be hard to measure. In FX in particular, many markets do not report trade information, or they report with a sufficient delay such that the information has no predictive utility. Even for markets that report instantaneous trade information, you would need a good piece of software to capture every bid, ask, trade, and trade size, and store them in an array, in order to compute order flow, an operation that most retail trading software cannot accomplish. However, this barrier to entry may just mean that there are still decent alpha to be extracted from this indicator.
Now, a bunch of public service announcements ...
===
A new algorithmic trading platform called Rizm designed for retail traders is now available. You can sign up for their beta trial here.
===
Quantopian has created an event-driven version of my gold/gold-miners arb strategy with source codes and analysis available. I find that the performance metrics clear and useful: better than the output from my own backtest programs! (Quantopian is a platform where you can share backtest results and codes with other traders.)
===
Arbmaker is a platform for pair traders, and it incorporates software for cointegration tests, has integrated data feed from many vendors, and allows automated order submission to Interactive Brokers. Neural networks and Kalman filter are also included.
===
Finally, I will be giving a talk titled "Backtesting and Its Pitfalls" at the World MoneyShow at the Metro Toronto Convention Centre on Saturday, October 20. Interested readers can register here.
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