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August 9, 2016 by Steve

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This is a Guest Post by Alex @MacroOps which was originally posted atThe 3 Pillars Of
Trading Performance

As an active trader, there are 3 key factors of your strategy that you need to pay close
attention to. Theres no holy grail in trading, but tweaking and maximizing these 3
things can get you pretty damn close to one.

We refer to these factors as the 3 pillars of trading performance:

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Pillar #1 Edge

Edge is a concept that decades of trading literature have beaten to a pulp. Youve
heard it a million times:

You need a positive edge to win long-term.

And its 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.

Theyre 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
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management or really any number of other factors that go into an eective trading
strategy.

The stronger your edge, the more profitable youll 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 dier between strategies. If
you expect to increase the frequency of your deep value strategy to a million
opportunities a day, youre out of your mind. At that point youll 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 oen 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?

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For example, if youre a deep value investor, are you looking at as many markets as
you could be to find the best deals? If youre only investing in US equities, would a trip
into the foreign markets increase the frequency of the value propositions youre able
to find?

The more oen 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
dierence 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.

Heres 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 dierent 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.

Lets 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

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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 o 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, dont 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 cant apply leverage, and you want to make more than 5% a year, then youre
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 Bs 15% a year with 30% volatility.

Creative uses of leverage in your investment strategy will put you leagues above other
investors without leverage.

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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 oen. And maximizing your leverage
means juicing your capital base.

But heres where it gets tricky. You cant blindly maximize each pillar individually.
Youll end up destroying your strategy and landing yourself in the poorhouse.

The problem is that each pillar aects 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.

Great!

You end up increasing your expected value per trade through a larger edge. But
before you run o to raise a few hundred million, you need to consider what are
youre giving up to achieve that higher edge.

The answer is that youre giving up your frequency.

If you make $2 a trade on higher timeframe monthly charts, which provide a

frequency of 25 trades a year, youll 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. Thats 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 HFTs do what they do. Yes, smaller timeframes are noisy,

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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 diicult. 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 dierent 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 isnt worth it. Might as well throw your money into a Vanguard
fund or something.

But heres where leverage can make all the dierence. 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.

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Heres another example. Say your strategys 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 its muddled and a little drab, but what the hell, youve been in a dry
spell lately so its 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 youre not thinking about leverage, you need to start. Youre 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 thats just
one part of the puzzle. Its playing a 2-D game. You need to look 3D and beyond

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How do you approach trading? For our methods click here.

For more posts and informationabout Alex @MacroOps you can check out his
website Macro-Ops.com.

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