Equity Quant > Trading Strategy
TRADING APPROACH (SUMMARY)
Equity-Quant.com's strategy is basically an equity long/short strategy (nearly market neutral), i.e. it holds both long and short positions in a 50 stock portfolio of the most highly capitalized US companies. The strategy is not exactly market neutral (ratio long/short = 1.25) in order to follow the prevailing upward market direction. The portfolio is rebalanced weekly, although the strategy works in all time frames - from daily to monthly charts. Unlike most trading programs which trade a single stock, the Equity Quant trading program analyses a stock portfolio, which makes it unique and ahead of the competition.
The strategy uses statistical methodology (ARIMA model) and not classical fundamental or technical analysis. There are no classical indicators which attempt to forecast market direction, no pattern recognition techniques, no fundamental analyses and no trading rules based on trader's experience; It trades by numbers and does not forecast anything - it is a "numbers crunching machine". Since this strategy is not correlated with the swing or trend following trading strategies, it can be an excellent complement to them.
The portfolio composition is calculated by a proprietary computerized program, based on ARIMA (Auto Regressive Integrated Moving Average) model and position size management. Unlike other pair trading strategies, our program is much more sophisticated and seeks for arbitrage opportunities between all of the 50 stocks, each against other. It gives specific position size adjustments for the 50 stocks comprising the portfolio. The resulting positions are then implemented in the market. The trading system is always in the market, but portfolio weights are adjusted on weekly basis.
The combined long/short leverage is low and fixed at 0.30. Long only leverage is 1.5 and short leverage is 1.2. Depending on the preferred risk tolerance level, the leverage can be further reduced, i.e. smaller position sizes can be traded then those calculated for the nominal account size. The recommended account size for the strategy is $100,000, although the strategy can work with as little as $50,000 (depending on commission costs).
A newer and much more complex version of the program for 100 stocks (the top 100 most highly capitalized companies traded on NYSE) is being developed. That system yields better risk adjusted returns, but it can be traded in accounts larger than $150,000 (due to the larger commission costs). Qualified eligible investors who might be interested in the Equity Quant 100 trading strategy can contact us directly to discuss for possible cooperation.
Fig. 1. Stock price chaos: EQ-50 stock prices, adjusted for dividends and splits (Data source: Finance.yahoo.com)
PORTFOLIO APPROACH VS. SINGLE STOCK TRADING
Instead of betting on any single stock, our trading system analyses a 50 stock portfolio - the Dow Jones Industrial Index universe plus other 20 very liquid NYSE stocks. We elected to trade stocks of well-established companies ("blue chip stocks") for their relative safety, reliability and excellent liquidity. By trading 50 stocks we achieve our objectives:
- We diversify trading. By trading 50 stocks simultaneously and in small quantities we cannot make a single major mistake by entering long (or short) at the wrong moment and with the wrong stock. We do not attempt to time or predict the market. Anyone who claims otherwise is deeply mistaken.
- We minimize the exposure to the systemic market risk. Since all stocks tend to move following the market trend, by trading long/short we minimize the exposure to this aggregate risk.
The Equity Quant 50 strategy extracts profits from the price chaos. Apart from the systemic risk, there is also a "idiosyncratic risk", which is specific to individual stocks (Fig. 1). By adjusting portfolio weights (position sizes of individual stocks), we try to keep our 50 stock portfolio relatively insensitive to the systemic risk, while extracting profit from the relative "miss-pricing" of individual stocks. This doesn't imply, however, that this type of trading is riskless. Based on backtesting results (Fig. 2) it is remarkable that Equity Quant's long/short strategy was profitable in a rising market (1991-1998), declining market (2001-2003) and sideways moving market (1999-2001 and 2004-2006).
Fig. 2. Strategy cumulative return (non-compounded). $1,000 without profit reinvestment would grow 967% to $10,670. Fig. 3 shows how would the same investment exponentially grow if the profit was reinvested.
Fig. 3. Value Added Monthly Index (VAMI) -
hypothetical growth of $1,000 compounded monthly.
By reinvesting the trading and compounding monthly
(not decreasing the trading size after a losing month), a $1,000 investment
would hypothetically grow into $9,892,094 in 20 years (note the VAMI is shown on a logarithmic scale). That's
989,109% profit on the initial investment, or average compound annualized rate of
return of 
. By
reinvesting annually the same $1,000 initial
investment would grow 199,466% into $1,995,661, at average annualized compound ROR
of 
. An
equally weighted portfolio of 50 stocks without
dynamical adjustments and without profit reinvesting (by extracting profit and
keeping portfolio size at $1,000) would only yield $3,600 in 20 years - a 360%
cumulative return on the initial investment, at average annual arithmetic ROR of
360%/20=18%.
Fig. 4. Monthly rates of return (red bars). The blue line shows the average monthly ROR for the life of hypothetical trading
PROFITABILITY VS. RISK
Backtested profitability was pretty stable, with average compound annual rate of return of around 46%, before commissions (Fig. 2 and 3). The monthly rate of return (ROR) plot (Fig. 4) clearly shows that most months finished in the positive territory. The profit factor, defined as a sum of positive monthly returns divided by the sum of negative returns is 6.45, i.e. $6.45 were gained per each $1 lost.
The profitability looks to be persistent in long run. Despite the long term profitability, there are occasional drawdowns (the blue line in Fig. 5), which is the ultimate source of risk in this type of trading. To limit the downside risk, we carefully determined the leverage, i.e. the trading size relative to account size. The actual long/short leverage, which we define as a ratio between (the long minus short position size) divided by (the current account value), is constant and fixed at 0.3.
The ratio (average monthly ROR)/(average drawdown) - magenta line in diagram Fig. 5 - for the entire backtesting history is almost constant and equals 1.65. The Calmar Ratio (average annual ROR)/(maximum intramonth drawdown) was 1.74 - the green line in diagram in Fig. 5. If we exclude the September 11, 2001 drawdown (-27.24%), the maximum intramonth drawdown is less than 15%. The worst drawdown, on month-end-to-month-end basis was -10.96% (September 11, 2001 intramonth drawdown inclusive). Interestingly, the October 1987 market crash did not produce a remarkable drawdown with EQ-50.
Fig. 5. Strategy Drawdowns
REINVESTING THE PROFIT
The Equity-Quant.com's strategy is convenient for compounding, or profit reinvesting. This means that we can easily increase the trading size as the profit increases the account value. Reinvesting can be done annually (the blue line in Fig. 6) or monthly (green line). The red line shows the relative trading size, i.e. we increase the trading size on a new equity peak. We hold the trading size unchanged, not decreasing it during a period of drawdown. The position sizes and position size changes in our newsletter are given for a $100,000 nominal account size. If account value is different from $100,000, all position size figures should be proportioned.
Fig. 6. Different compounding strategies: monthly compounding is superior over annual compounding method. (Note the semi-logarithmic scale). The red line shows the Monthly Reinvestment Factor - the trading size relative to initial investment. It is remarkable that the reinvestment factor gradually grows (never going down) from 1 to 12,445 in 20 years.
To see a trading plan example, see this sample issue of the Equity Quant 50 Trading Newsletter.
