If you want to improve your investment strategy and increase your returns, there’s 3 key factors you need to focus on.
We call these factors the 3 pillars of trading performance:
Pillar #1 – Edge
Edge is a concept that decades of trading literature have beaten to a pulp. You’ve heard it a million times:
“You need a positive edge to win long-term.”
And it’s absolutely true.
In trading, edge is your ability to select trades that perform better than random.
You can think of edge as the process used to generate and execute entry and exit signals. Professional traders spend a majority of their time on this process alone.
They’re constantly asking themselves questions like:
How can I refine my research to enter the absolute best fundamental plays?
How can I better time my exits and entries using quantitative cues?
How can I cut my losses through improved exit parameters?
The more they improve their entry and exit signals, the stronger their edge becomes.
To increase your own edge, relentlessly search for holes to plug in your trading process. This could involve a stronger focus on improving your fundamental analysis. Or maybe refining your profit taking approach. It could also mean tighter risk management or really any number of other factors that go into an effective trading strategy.
The stronger your edge, the more profitable you’ll be.
Pillar #2 – Frequency
Frequency refers to the amount of times your edge expresses itself in the market.
HFT firms may see a million opportunities a day to exploit their edge.
A deep value manager, on the other hand, may only see his edge show up a few times a year.
Frequency matters because the more opportunities you have to apply your edge, the higher your earning potential that year. Ideally you want to apply your edge as many times as possible.
But of course keep in mind that the optimal frequency will differ between strategies. If you expect to increase the frequency of your deep value strategy to a million opportunities a day, you’re out of your mind. At that point you’ll be investing in everything and anything, with concept of “value” thrown out the window.
This is where frequency can become a double-edged sword. The key is to increase it in a way that does not degrade edge.
Few people think about the trading process from the frequency angle. They tend to focus only on cultivating an edge, but never give any thought to how often that edge can be executed.
Look at your own trading process.
What type of edge are you developing?
Is its frequency optimal for your particular strategy?
For example, if you’re a deep value investor, are you looking at as many markets as you could be to find the best deals? If you’re only investing in US equities, would a trip into the foreign markets increase the frequency of the value propositions you’re able to find?
The more often you apply your edge, the more money you can extract from sweet Mr. Market.
Pillar #3 – Leverage
Leverage, like frequency, is rarely discussed, yet extremely important. It can mean the difference between average and superior performance.
Leverage simply means deploying extra capital above your cash level in the market.
Now a lot of people will tell you that using things like margin to add leverage to your trades is dangerous. And that may well be true for the green-behind-the-ear trader, but proper use of leverage for a professional is essential to their success.
Soros’ Quantum fund would routinely achieve leverage levels of 4 to 1. That means that for every million dollars in their account, Soros and Druck had 4 million in bets out in the market.
Here’s Soros himself on the concept of using leverage:
It is a rather unusual structure, because we use leverage. We position the fund to take advantage of larger trends – and then, within those larger trends we also pick stocks and stock groups. So we operate on many different levels. I think it is easiest if you think of a normal portfolio as something flat or two-dimensional, as its name implies. Our portfolio is more like a building. It has a structure; it has leverage. Using our equity capital as the base, we construct a three-dimensional structure that is supported by the collateral value of the underlying securities. I am not sure whether I am making myself clear.
Let’s say we use our money to buy stocks. We pay 50 percent in cash and we borrow the other 50 percent. Against bonds we can borrow a lot more. For $1,000 we can buy at least $50,000 worth of long-term bonds. We may also sell stocks or bonds short: we borrow the securities and sell them without owning them in the hope of buying them back later cheaper. Or we take positions – long or short – in currencies or index futures. The various positions reinforce each other to create this three dimensional structure of risks and profit opportunities.
If you want to blow the doors off the average performance you see in the market, you need to focus on increasing your leverage as much as possible.
Now the obvious caveat to this statement is that you should never press your leverage to a point where you risk bankruptcy. A proper risk management system will tell you the max amount of leverage you can apply per trade without going broke. For example, don’t go trade a 10 lot of E-minis on a $10,000 account. That would not be wise…
Intelligent uses of leverage are critical because they not only increase returns, but they can actually reduce overall portfolio risk too.
Ray Dalio was one of the first investors to popularize this concept (also known as risk parity).
Say Asset A returns 5% a year above the cash rate, with a volatility of 7%.
And Asset B returns 15% a year above the cash rate, but with a volatility of 30%.
Which is the better deal
If you can’t apply leverage, and you want to make more than 5% a year, then you’re forced to go with Asset B.
But if you understand how to apply leverage, you could easily lever up 3 to 1 (borrow 3 units for every 1 unit you own). This would allow you to buy 4 units of Asset A instead of 1, transforming your returns to 20% a year with 28% volatility — a much better deal than Asset B’s 15% a year with 30% volatility.
Creative uses of leverage in your investment strategy will put you leagues above other investors without leverage.
An Optimization Problem
Once you understand the 3 pillars of trading performance, your goal should be to maximize each.
Maximizing your edge means winning more and winning larger. Maximizing your frequency means applying that edge more often. And maximizing your leverage means juicing your capital base.
But here’s where it gets tricky. You can’t blindly maximize each pillar individually. You’ll end up destroying your strategy and landing yourself in the poorhouse.
The problem is that each pillar affects the other. Adjusting one leads to a change in another one.
Say for example you decide to lengthen your investment timeframes. You believe higher time frames have less noise and stronger signals.
You end up increasing your expected value per trade through a larger edge. But before you run off to raise a few hundred million, you need to consider what are you’re giving up to achieve that higher edge.
The answer is that you’re giving up your frequency.
If you make $2 a trade on higher timeframe monthly charts, which provide a frequency of 25 trades a year, you’ll make 50 bucks.
But what if that same strategy on lower timeframe daily charts made $.50 a trade, with a frequency of 200 trades a year? The daily program, despite the lower edge (profit per trade) would generate $100 a year in profits. That’s twice the returns of the higher timeframe strategy!
In this case the strategy with the smaller edge actually makes more money per year. This is why those pesky HFT’s do what they do. Yes, smaller timeframes are noisy, making it harder to create a meaningful edge, but if that smaller edge has a higher frequency than a larger edge, then it may actually be optimal.
This is why optimization becomes difficult. You can beef up your edge by adding more criteria or filters to produce a better signal, but by being more selective, you decrease the frequency of your entries.
It may actually not be in your best interest to beef…
You see a similar problem when reversing the frequency/edge relationship.
Say you want to jack up the frequency in which you apply your edge. To do this, you start looking for more and more chart set-ups. But at the same time, you start loosening your trade criteria further and further.
At a certain point you realize that every tea leaf and chart candle has become a trade, and before you know it your trading edge erodes into oblivion.
In this case, increasing frequency hurt you because your edge degraded in the process.
There are even more problems when it comes to leverage optimization.
As we explained before, the goal with leverage is to maximize as much as possible without exposing yourself to bankruptcy risk. There are many different ways to creatively (and safely) do this.
Say for example you have a lukewarm strategy that uses stock and ETFs. And its returns end up being the same as any standard buy-and-hold passive strategy. If this is the case, the strategy isn’t worth it. Might as well throw your money into a Vanguard fund or something.
But here’s where leverage can make all the difference. You may be able to take that same strategy, and instead of using stocks and ETFs, use futures to apply concentrated leverage. All of a sudden you might have something halfway decent on your plate.
Here’s another example. Say your strategy’s entry signals vary in strength.
Sometimes the signal is pure and sexy like the dime standing at the end of the bar. And other times it’s muddled and a little drab, but what the hell, you’ve been in a dry spell lately so it’s still worth your time.
Having the ability to leverage up or down depending on the strength of your signal can lead to much better performance. Your best trades can have the most oomph behind them, while your lesser trades can hang back a bit.
If you’re not thinking about leverage, you need to start. You’re missing out on a crucial pillar that will help juice your performance to Market Wizard heights.
The next time you approach your trading process, go at it with the 3 pillar optimization problem in mind.
Recite these three questions to yourself on a weekly basis:
How can I increase the expected profitability (edge) of each my trades?
How can I optimize my trade frequency?
How can I leverage my current capital?
And when it comes to optimization:
Are the three pillars of my strategy flexible?
If so, can I manipulate one and still come out with a juiced up bottom line?
Start to look at your trading process from a multi-dimensional point of view. Focusing on improving a particular setup or exit methodology is good and all, but that’s just one part of the puzzle. It’s playing a 2-D game. You need to look 3D and beyond…..
For more information about how our team uses these 3 pillars to build a trading strategy, please click here.