Profit Making Mantras:- Day Trading

A lot has been said about Efficient Market Hypothesis. According to most academics, markets are almost Strongly Efficient, and it is impossible to make any profit based on past stock performance, or fundamental analysis.
Though there have been many arguments for and against market's efficiency, most practitioners believe that markets are not efficient. Though hold only money managers and investment funds have not been able to do better than market, a lot of hedge funds which use a mix of different strategies have been able to show strong results over long periods.

I will like to talk about a strategy that seems to work a lot number of times. I have been using this since last week of December and it has worked on most days.

Short and Cover - Strategy


The basic principle behind this strategy is that in the short term, investors overreact to a lot information. Thus, a positive earning guidance may shoot up the stock price of a company much beyond the actual material potential of the news (earning guidance in this example). Similarly, a bad news in the market may lead investors to pull out a particular stock holding.
In general, I believe that investors react more towards a positive news than towards a negative news. This may be particularly true in the trading period that is associated with my research and results (Dec'09 to Jan'10). As US and rest of the world was considered to be coming out a long recession, and with companies 4th quarter earning numbers expected to beat analyst estimate, the reaction to news was probably way beyond their material impact on the stock's intrinsic value.

Based on this insight, I started testing this trading strategy:-

1. Screen stocks with a one-day return of over 10%
2. Research the news associated with these stock movements
3. If material was considered non-material, then short that stock
4. Look for covering that position close to the end of day, or next day morning.

Now this strategy involves a lot of risk, specially the risks involved with Shorting stocks. Liquidity is one of the primary issue that one should be aware of when using such strategies. In my portfolio, I looked at stock with market cap of $80M+, and average daily volume of 50,000+.


A snapshot of this portfolio is given here:-

Investing Ideas...

As I promised earlier, I am going to delve into some details of how we invested in different strategies. Just for a recap, the three strategies that I mentioned in my first blog were:-

1. Creating an efficient portfolio out of ETFs.

2. Trading in mis-priced Options

3. Daily trading based on specialized strategy

The hypothetical situation is this: You are a portfolio manager. You have just received $10 million from your clients, who wants you to maximize risk-adjusted return, has an investment time horizon of two months and is investing same amount with ten other portfolio managers. He will increase his allocation to your fund to a $1 billion if you perform better than everybody else.

When we started thinking about this project, the first thing that came to my mind was to look for arbitrage trades. Arbitrage trades are those that generate a positive return without taking any risk. For example, if I can buy some securities from A and sell those to B at the same time and at a higher price, then I earn a return without taking any risk. The reason that I went for such trades was the whole idea of Sharpe Ratio maximization.

Seasonal Effect in Equities

Various strategies have been documented to take advantage of season effect of equity markets. The notable seasonal effects are1:-

1. End of December Effect
2. January Effect
3. Turn of the month
4. Window Dressing
5. Pre-holiday Rally
6. Monday Effect
7. Lower Your Taxes

Though these have been documented in various books and web sources, I tried to look at how our year cycle effects different sectors of market. The two underlying principles in all my strategies are

1. investors give a lot more weight age to short information than long term information
2. more media coverage - stronger effects. e.g. if two sector are getting positive information - and one sector is getting more media coverage than another, then this sector's short returns will exceed others even if the fundamentals are exactly same

Now I will get down to some of the data that I collected to compare the performance of different sectors over the year for last 5 years.

1. Basic Materials: This sector includes chemicals, metals, precious metals, forestry and no-metals, etc.The data for past five years show a cyclicity in the sector as a whole. It will be more visible from following data: - 

       2. Capital Goods: The sector includes Aerospace & Defense, Construction & Agriculture machinery, raw material, mobile homes etc. The sector did come back in our investment period in three of last four years.

     3. Conglomerates: Conglomerates have done badly compared to S&P in all of the last four years.

  

                      

Investing Ideas

This is my first blog, and the first time I am discussing something in a public domain.

Over the past month and a half, I have been participating in a Hedge Fund Competition. The goal of my team was to generate high risk-adjusted returns over the period of two months.

I wanted to share our strategies, as these made a lot of money, and I believe that some strategies will keep on making money in future as well.


1. Creating an efficient portfolio out of ETFs.
2. Trading in mis-priced Options
3. Daily trading based on specialized strategy

More on this in some time...