Transactional vs Confidence-based Trading Strategies
Warning: extreme geekiness ahead.
I think folks sometimes have a difficult time understanding my approach to the markets seen in YK, Scotty, and the State of the Market report, because most traders come from what I’ll call a “transactional” school of thought rather than a “confidence-based” one.
Note: I just completely made those words up, so don’t bother googling them.
A traditional transactional strategy might go something like: buy X shares when moving average X crosses over moving average Y – sell the position and go short when it crosses under. I call this “transactional” because if we were to begin trading that strategy after a buy signal but before a sell signal, the strategy doesn’t work as designed because it relies on the sequencing of the market, or put another way, starting at the beginning of the trade and finishing at the end.
A confidence-based approach to that same strategy might look more like: as moving average X climbs farther above/below moving average Y, increase exposure to the market from -100 to 100% (and all the steps in between) with 0% being X=Y and +/-100% being X = +/- 3 standard deviations above/below Y.
That’s a little difficult to explain in text, but the difference is two-fold: (a) you could jump into the strategy at any point and it would have an opinion on the market, and (b) the strategy isn’t just trading a condition (i.e. X crossing Y) but expressing a confidence in that prediction from -100 to 100% and all the steps in between.
Side note: obviously you could scale into a transactional strategy as well and also call this a “confidence in the prediction”, but the vast majority of the time, transactional strategies do not – they have very binary entry/exit rules.
The confidence-based approach has two advantages.
First, and most importantly, it increases sample size.
In the transactional example above, each closed trade is a single observation. For something like 50/200-day moving average crossovers or a small/large-cap leader/laggard strategy, it could take multiple decades to generate enough trades to have any level of confidence in the strategy.
But in the confidence-based strategy, because of the introduction of the concept of confidence (and the fact that it’s radically changing from 0 to 100%) smaller units of time (such as days) can be treated as an observation.
Side note: well, not completely…in a very long-term strategy like 50/200-day crossovers the confidence value isn’t changing enough day-to-day, so no, each day is not an observation – but perhaps each month is, and that’s a hell of an improvement.
The second advantage is that it forces the trader to think of the portfolio as a sliding scale rather than X number of fixed positions (again, this could also be accomplished in a transactional system but usually is not). Not only are we using the binary condition to guide our trades (X crossing Y), but the strength of that condition as well. That added layer can do a lot to help a strategy focus exposure on those times when the market becomes particularly predictable and reduce exposure when it is less so.
The fly in the ointment is that most traders don’t have a sufficiently large portfolio to employ a confidence-based approach that is making fine adjustments to position sizes on a daily basis. Transaction costs would kill the goose.
That’s a big part of the reason why I trade leveraged mutual funds. No per-transaction costs mean that my own portfolios and all of the investor portfolios that are following our strategies via managed accounts receive, for all intents and purposes, the same results, regardless of the size of the portfolio, even though we’re changing positions (sometimes only very slightly) everyday.
Just one humble developer’s $0.02.
P.S. this will be the post I will point folks to when they ask me when the Scotty or YK strategies issue a sell signal. The answer? They never issue a sell signal…for that matter they never issue a buy signal. Every day is just another change in the strategy’s confidence in a given direction.
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