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Random Could Become the New Edge

Returns of many professional traders and hedge funds year-to-date are below the average return of random traders in SPY ETF market. Is random the new edge?

Let us start from the bottom:

  • Due to crowded trades in almost every conceivable factor, profit potential has decreased significantly.
  • The net effect of this multi-dimensional complexity is increased randomness.

In the 90s for example, it was the retail trader space that was crowded using naive tools such as technical analysis chart patterns and indicators. Professional traders, CTAs and hedge funds were able to profit by taking advantage of this “dumb money” inflow to the markets.

Nowadays, there is no much dumb money around as most retail traders were squeezed out of the markets in the 90s and those that survived were hit hard during the financial crisis and afterwards via quantitative easing induced invalidation of technical analysis.

Therefore, nowadays the battle for profit is mostly between professionals and markets are more efficient and random.

Below is a simulation of 20000 traders that use a fair coin to trade long SPY ETF. If before the market close the outcome is heads that is a signal to open a long position or stay long. If the outcome is tails, the traders close the long position. The period of the simulation is 01/02/2019 to 09/16/2019. Starting capital of each random trader is $100K and commission is $0.01/share for fully invested equity. There is no reinvestment of profits.

Simulation performed with DLPAL software.

Note the shape of the distribution of the net returns of SPY long-only random traders in the period considered: it is nearly normal with slightly negative excess kurtosis and positive skewness. The most interesting observation is that more than 95% of the random traders realize positive net returns.

The mean return is about 9.6% and a 10% test return ranks at 46.5%, meaning that this is the percentage of random traders that realized more that 10%. Note that buy and hold return is 21.1% and significant performance at the 5% level would require a return of at least 19.2%. Also note that 2.3% of the random traders realized returns above buy and hold, by chance of course. Those lucky traders are free to attribute their excellent performance to their skill…

Now, there was a lot of talk in the financial media about high returns of CTAs year-to-date. According to BarclayHedge, the return so far is 7.66% for 2019. This is even lower than the average return of random long only traders in SPY ETF year-to-date. This is quite disconcerting.

Is random the new edge, or at least a significant edge, after central banks have altered the dynamics of the markets and have driven out retail speculators that professional needed most to realize returns?

Should traders just toss a coin and hope luck will be on their side and they will end up in the far end of the right tail of the distribution?

In fact, most traders we come across in social media act are random although they think they are following some system or analysis of the markets. In reality, they are tossing a coin and if they are lucky the coin if fair and fairness is the upper bound. In many cases these traders are worse than random and their coin is biased against the prevailing trend because they are influenced by emotions and noise in social media.

Toss a coin or not, traders must do their homework. Tossing a coin is not as trivial as it sounds. It is often part of a sophisticated strategy.

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Simulation program: DLPAL


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