Using Perturbation Theory to Build Trading Models and Systems

I have recently finished reading Mr. Brian Greene’s book, The Elegant Universe. It is a fascinating book about string theory. One of the concepts Mr. Greene discusses is how physicists use perturbation theory to advance their knowledge and theoretical ideas.

Mr. Greene says that the mathematical framework of string theory is so complicated that physicists have to use approximate solutions and calculations, while initially ignoring some details. Later, these solutions and calculations are further refined as more details and knowledge are systematically included. The perturbative process can also be used to build trading models.

I had no idea of perturbation theory before reading this book, but I now feel it describes the process of how I created trading models. The stock market is also complicated and difficult to understand (probably more so then string theory). Initially, I began to systematically organize some variables, ideas, and concepts, while leaving others out. I began to create some general ideas, theories, and approximate solutions to trading. Later, with further testing, experimentation, and pain (the great teacher), I was able to increase my knowledge of how the market works, and I began to systematically include more details and concepts. This led to further refined ideas and theories which eventually became my trading models.

But here is some advice and a word of warning to traders out there—the key is to use a perturbative approach up to a point. The irony is that the more variables added to “refine” and “improve” a model, the more likely it is that the model will breakdown.

Mr. Larry Williams and Mr. Niederhoffer's, Daily Speculations

I like to read different blogs in order to educate myself about a number of issues and topics. One blog that I like is Mr. Niederhoffer’s, “Daily Speculations.” This blog contains some interesting topics submitted by a variety of individuals. The other day I read a comment by Mr. Larry Williams. He said,

“The other day I heard somebody say:
"Assuming the future behaves the same as the past, I reason that this way makes my funds efficiently used".
I wanted to say, my experience is that the past is never like the future so we waste valuable time and skills on a false postulate.
As I see it, it is better to have a core strategy to deal with equity drawdowns, etc –based on logic–as opposed to a strategy based on the past real results or back tested as that is for the most part a make believe world since it never happens quite that way again.”

Most system traders backtest their ideas and models in order to have some confidence to trade into the future. As a system trader I always think about the future and if it will resemble the past or not. I wonder if the ideas behind my models will ever fail going forward. Mr. Niederhoffer likes to speak about ever-changing cycles in markets. These ever-changing cycles may eventually cause the breakdown of trading models. Perhaps, this is true.

Mr. Williams has spent much of the past teaching traders to backtest ideas, etc. He has made money teaching and writing books that include backtesting, etc. Has something changed? In addition, I believe Daily Spec removed Mr. Williams initial comments (or perhaps I cannot find them), but I can tell you that Mr. Williams had a much different tone in that post regarding the use of backtested info and using it to trade with.

I agree with Mr. Williams about having a logical strategy to deal with drawdowns, but backtesting is not a waste of time.

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The Situation is BOSS

One business maxim of mine is that “the situation is boss.” High pressure, quick changing environments need decision makers who are flexible and adaptable. The situation is always the boss. Sometimes we want to impose our own ideas onto the situation in order to bring things under control. This may work; but I believe that most of the time the situation dominates and our decisions tend to be reactive. In other words, it is not what occurs that is important, but rather how we react to it, that is more important.

Climbing the Wall of Worry

There is the saying that strong markets climb the “wall of worry.” It sure feels like that nowadays. Tunisia, Egypt, Bahrain, Yemen, Syria, and Libya are rumbling to various degrees. The US has just entered into yet another war in the Middle East. Japan is glowing and no one seems to give a damn. Oil is over a $100 bucks a barrel. The US Government is negotiating to stay open for business a little bit longer. States are finding that they are facing critical shortages of something really important--money! Workers cannot find jobs. Greece, Ireland, and Portugal are desperate. The list seems to go on and on, yet the market seems to be acting pretty well…hmmmm…

The Red Queen Rules Europe

It seems to me that the European debt problem can be best understood from the standpoint of the Red Queen hypothesis. This evolutionary hypothesis states that continuing adaptation is needed in order for a species to maintain its relative fitness among the systems that it is evolving with. The Red Queen hypothesis comes from the line in Lewis Carroll’s book, Through the Looking Glass, "It takes all the running you can do, to keep in the same place."

It seems to me that Greece, Ireland, and now Portugal, are running and going nowhere fast. These countries must evolve relative to their European counterparts or else they will reach a point where their economic, political, and social systems will breakdown. In my opinion, the European debt problem is evolving to outright defaults and bigger problems.

SOME ADVICE FROM MR. WARREN BUFFETT

One of Mr.Warren Buffett's business tenets is to "Never Suck Your Thumb." That means that, at a certain point, you've got to stop thinking — and start acting.

In his 1989 annual report, Buffett explained how he learned the thumb-sucking lesson the hard way: "It's no sin to miss a great opportunity outside one's area of competence. But I have passed on a couple of really big purchases that were served up to me on a platter and that I was fully capable of understanding. For Berkshire's shareholders, myself included, the cost of this thumb-sucking has been huge."

The only way to make money is by pulling your thumb out …

PLOTINUS AND BUILDING TRADING MODELS

Plotinus, the ancient Greek philosopher, did not have the creation of trading models in mind when he wrote this. Nonetheless, I think there are similarities between the creation of our trading models (our “statues”) and creating ourselves…

Withdraw into yourself and look. And if you do not find yourself beautiful yet, act as does the creator of a statue that is to be made beautiful: he cuts away here, he smoothes there, he makes this line lighter, this other purer, until a lovely face has grown upon his work. So do you also: cut away all that is excessive, straighten all that is crooked, bring light to all that is overcast, labour to make all one glow of beauty and never cease chiseling your statue, until there shine out on you from it the godlike splendour of virtue, until you shall see the perfect goodness surely established in the stainless shrine.

When you know that that you have become this perfect work, when you are self-gathered in the purity of your being, nothing now remaining that can shatter that inner unity, nothing from without clinging to the authentic man, when you find yourself wholly true to your essential nature, wholly that only veritable Light which is not measured by space, not narrowed to any circumscribed form nor again diffused as a thing void of term, but ever unmeasurable as something greater than all measure and more than all quantity—when you perceive that you have grown to this, you are now become very vision: now call up all your confidence, strike forward yet a step—you need a guide no longer—strain, and see. This is the only eye that sees the mighty beauty…

The Myth of Sisyphus

Mr. Albert Camus, who won the Nobel Prize in Literature in 1957, wrote The Myth of Sisyphus. I recently read a part of it. Sisyphus was a character from Greek mythology who was condemned to live life in a vicious circle; push a rock up the hill, watch the rock roll down the hill, push a rock up the hill, forever. Sounds like fun.

Mr. Camus believed that Sisyphus was an absurd hero. I think traders are absurd heroes. We try to make money trading a dynamic thing called the market. We can have our great runs, only to see the market roll our accounts right back to where we started. We push onward and upward again, only to once again see the market roll us back down. This cycle can be vicious and can make us feel that what we are doing is absurd. Nonetheless, faith, persistence, and determination is what allows us to face absurdity and uncertainty each day; just like Sisyphus.

Cheers to all you absurd heroes out there, keep pushing your rocks…

Another Favorite Guru

Another favorite guru of mine, Mr. Barton Biggs...

ONE OF MY FAVORITE STOCK GURUS SAYS...

One of my favorite gurus over the years has been Mr. Birinyi. He recently gave a long term bullish outlook on the US stock market. Check it out.

OILY PIGS

If oil prices stay high for a prolonged period of time it will be put incredible pressure on the Greek, Irish, and Portuguese economies. The risk of default increases as the price of oil rises. European leaders will need to be more proactive. Mr. Trichet is talking about raising interest rates, while here in the United States, Mr. Bernanke is giving indications that rates will not be raised. Why is Europe jumping so quickly to raise interest rates? Yes, I know the inflation fear is present, but default fears need to be addressed. I believe the US stock market is starting to smell it.

The Global Misallocation of Capital

Nowadays, global capital flows rapidly in and out of assets around the world. Investment managers, hedge funds, and traders of all types seek to make a buck wherever they can. Today it is oil; tomorrow it will be something else. The point is that greed and profit moves the prices of assets probably more than they are worth, just as fear and losses move prices lower than their “true” value (if you believe in intrinsic and fundamental value).

As the price of oil becomes more volatile, and as trading firms move their capital in a herd like, stampeding fashion, oil will pull in global capital. This will inevitably create a worldwide misallocation of capital. One has to wonder how the global misallocation of capital will affect our future. Companies around the world will have to consider how the recent moves in oil will affect their business. Government policy makers will have to consider the possibility of a slowdown in economic growth, how this will affect interest rates and inflation, and consumers will think twice before purchasing any goods and services. The problem is that the speed which capital moves and the increase in the volatility of prices it brings, will exaggerate the consequences and effects of all the decisions being made today.

MIND OVER MONEY

I recently watched a NOVA special entitled “Mind Over Money.” I thought it was pretty good. It discussed the two leading and opposing theories regarding markets and economic behavior. On one side there are the rational, self-interested market participants. These types were first defined by Mr. Invisible Hand himself, Adam Smith. On the other side are the behaviorists. The behavioral school of economic thought predominantly concerns itself with the idiotic decisions and non-understandable side of irrational human beings making decisions. The argument basically boils down to whether we are smart and rational people, making sound economic decisions, or that we are idiots and irrational, who make stupid decisions based on our thoughts and feelings, etc.

The show touched upon efficient markets, with Mr. Eugene Fama leading the charge for the smart and rational people creating efficient markets. Got May 6, 2010? Mr. Robert Shiller, aka. Mr. Irrational Exuberance, led the charge for those on the behavioral side. “By the way Robert, got a house to buy or sell?

It was worth watching for an hour, I especially enjoyed the bidding for a $20 bill that some fool was willing to pay $27 to 28 for…genius…maybe Mr. Shiller would like to sell his home to that guy…everyone knows that home prices never go down…

TRADING CDS AIR

The Wall Street Journal recently reported that banks and hedge funds are trading credit default swaps on General Motors bonds that do not exist. All I can say is here we go again. How can these kinds of things go on? I am all for free market capitalism, but when my money and yours is being used to keep these guys operating when they F*up, then something has to give. The value of derivatives is linked to some sort of “underlying” asset. It now seems that the underlying security can be a concept and an idea. Wow, got to give credit to the genius that brought this about….

IMMANUEL KANT AND MARKET VALUE

I was recently at my local library’s book sale and came across a set of Harvard Classics that I could not pass up. I bought them and began to read Immanuel Kant’s, Fundamental Principles of the Metaphysic of Morals. Mr. Kant can be pretty dense and obscure. Reading his writings reminds me of a line by the comic, Steve Martin, who believed he had taken just enough philosophy to screw him up for the rest of his life. Reading Mr. Kant can have a similar effect.

Nonetheless, Immanuel Kant can be pretty easy to understand (sometimes) and there were a few brief moments of pure, lucid thought that I could follow. I found the following interesting…

“In the kingdom of ends everything has either Value or Dignity. Whatever has a value can be replaced by something else which is equivalent; whatever, on the other hand, is above all value, and therefore admits of no equivalent, has a dignity.

Whatever has reference to the general inclinations and wants of mankind has a market value; whatever, without presupposing a want, corresponds to a certain taste, that is to a satisfaction in the mere purposeless play of our faculties, has a fancy value; but that which constitutes the condition under which alone anything can be an end in itself, this has not merely a relative worth, i.e., value, but an intrinsic worth, that is dignity.”

As traders we always deal with the concept of value and price. Stocks can have market value and fancy value. I find it interesting that the word and concept Mr. Kant uses is “dignity” for something which is beyond value. As a trader this tells me to short fancy value and go long dignity.

Mr. El-Erian and the Libyan Crisis

Mr. El-Erian was interviewed by Mr. Keene on Bloomberg regarding the recent crisis in Libya. The interview revolved around a few issues that one would expect; the price of oil, geopolitical risk, inflation, etc. What I thought was interesting was that near the end of the piece Mr. El-Erian mentioned the US Dollar. He noted how the flight to quality and safety that usually occurs during these kinds of situations barely moved the dollar. Mr. El-Erian stated this is because investors and traders are realizing that the United States is being perceived more negatively and as having a higher risk than in the past. I agree with him. The world's perception of the US has changed and is changing...

Using Barron's Statistics

When I was young I used to read Barron’s from cover to cover each week. I loved the statistics at the back of each issue. I would always try to figure out how I could use them. Nowadays, I still look at Barron’s from time to time, but I like this page the most. It provides the SP500 earnings, which are currently $71.86. Trying to figure out the growth rate of these earnings, and what multiple the market will trade at, is a pretty good way to get an idea of the value of the market. I do not trade on this information, but I like to look at it as a reality check.

Are More Bailouts Coming for Our States?

What will happen with the financial situation of state, local, and municipal governments? There is no question that some states are in bad shape, for example, Illinois, New Jersey, and California. Other states are better off. This question will become a bigger issue as the year goes on. Some argue that the financial situation of state and municipal governments is not a huge problem and can be handled. Others argue that this is a big problem that will become much larger.

We have not heard a single thing from Washington about what to do with this problem. My feeling is that the politicians are all hoping that the issue will just go away. In my opinion, it all comes down to the following; years of poor political leadership, corruption, unreasonable financial assumptions, greed, and lack of fiscal control have created the problem. Are more financial bailouts and larger budget deficits for our nation on the horizon?

GOLDMAN'S STOCK FORECAST FOR 2011