kaufman key points - cmt association – … key points important ideas from the 5th edition risk...

KAUFMAN KEY POINTS Important ideas from the 5th edition

Risk Management Volume, Open Interest, Breadth

____________________________________________ IMPORTANT CONCEPTS FROM TRADING SYSTEMS AND METHODS, 5TH EDITION

Risk Management What is the best way to manage risk? What are the pros and cons of the tools we use?

Robust Testing and System Development How much data do we use? How do we decide that a system is working? What parameters do we choose?

Volume, Open Interest, and Breadth Some comments

____________________________________________ RISK MANAGEMENT NOT RISK MEASUREMENT

The Tools At the trade level: Stops Profit-Taking Position Sizing At the portfolio level: Vol-adjusting sectors Vol-adjusting the portfolio (target vol) Value-at-risk

____________________________________________ RISK MANAGEMENT AT THE TRADE LEVEL

Stop-Loss Doesn’t Always Work Fixed stops (points) only work at once price

Use ATR (20-day?) from entry Use a trailing stop triggered after minimum profit is reached

Typically you get out at the worst place If you get out of a macrotrend position, and the trend continues, you may miss the fat tail – you need to be able to reenter

ENTRY STOP AND TRAILING STOP

____________________________________________ PROFIT-TAKING WORKS FOR FAST TRADING

Profit-Taking works because of noise Because of noise, we expect prices not to continue in the same direction, then Take profits on extreme good moves Wait to exit on extreme bad moves As with stops, taking profits fights with the trend Always measure profit targets from the trade entry point using: factor x ATR The factor is typically between 3.0 and 4.0

PROFIT-TAKING AND RESET

____________________________________________ POSITION SIZING

All positions should start with equal risk If a trade has more risk then it must generate a higher return Equal risk gives each trade an equal chance of affecting the

results, then it maximizes diversification For stocks: Fixed investment/share price (no leverage) For futures: Fixed investment/20-day ATR (allows leverage) Increase position size as net equity increases; do not decrease

size as equity declines. Deleverage as the portfolio declines past 1.5 stdevs.

POSITION SIZING FUTURES AND STOCKS

____________________________________________ MANAGING PORTFOLIO VOLATILITY

Clients Expect a Predetermined Amount of Risk (Target Volatility) This works for futures but not stocks Calculate the daily volatility using the standard deviation of the 20-day returns x sqrt(252) Increase all position sizes equally if the volatility is 20% below the target Decrease the all position sizes equally if the volatility is 20% above the target Most of the gain comes from leveraging up A small amount of risk is reduced by deleveraging

VOLATILITY STABILIZATION

____________________________________________ VALUE-AT-RISK: PLAYING WITH THE BIG BOYS

Measuring Risk Expectations The measure for expected risk is “value-at-risk” (VaR) It is calculated by taking today’s positions and projecting them back on

the last 252 days of prices Then sort the simulated daily returns lowest to highest and find the return

at the 5% level (e.g., entry 95 of 100) The negative return on that day is the amount you can lose at the 5%

probability level. Companies will require that you keep that number under 3% to 4%.

If the value is greater than, say 3%, reduce all positions by the factor that brings it to 3%

The results is that you reduce the system risk more than you reduce the returns, therefore the information ratio should increase

____________________________________________ VOLUME, OPEN INTEREST, AND BREADTH

VOLUME Volume is tricky because it varies so much Granville’s On Balance Volume is the best I’ve found: If price rises then add price x volume if price drops then subtract price x volume Substitute the index for price in a moving average

VOLUME SPIKES Volume spikes are a good place to remove a trade because they tend to be at extremes A spike can vary in definition from 2x to 5x average volume

60-DAY TREND OF PRICE AND OBV

VOLUME SPIKES IN AAPL (FACTOR 2)

____________________________________________ VOLUME, OPEN INTEREST, AND BREADTH

Open Interest Only exists for futures markets I have had better results using open interest instead of volume because it’s more stable Be careful of the contract patterns. Open interest can build at the beginning and decline at the end of a contract.

ED AND SP VOLUME AND OPEN INTEREST

____________________________________________ VOLUME, OPEN INTEREST, AND BREADTH

Breadth Only for equities Available on CSI as UVDV or MKST Typically interpreted as Rising breadth confirms rising prices and

Falling Breadth confirms falling prices. There is large combination of advance-decline calculation Upside/Downside ratio would seem the most sensible Its greatest value may be in identifying the shift from large cap

(dow and SP) to smaller cap. Typically the smaller caps lead the market turns and during periods of uncertainty, investors move to large caps. It becomes the leading indicator of a bull market.

ROBUST RESULTS

ROBUST SYSTEM DEVELOPMENT AND TRADING GIVE STABLE PERFORMANCE Use as much data as possible. Markets change but a robust system needs to be

tested on as many patterns as possible A system is working if most of the tests (> 70%) are profitable for a reasonable

range of parameters. A macrotrend system satisfies this criteria We can’t know which parameter/calculation period will be best in the futures, so

we seek the average by using a fair distribution of calculation periods and netting the results.

My philosophy is to assume as little as possible: Equally weight everything where possible Use multiple parameters to get an average Volatility adjust to maintain constant risk

Questions?

Thanks for Attending!

____________________________________________ PERRY@KAUFMANSIGNALS.COM