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Trading Strategies and Market Color: The Benefits of Friendship with

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 Trading Strategies and Market Color: The Benefits of Friendship

with Quantitative Analysts and Financial Engineers

Ravi Kashyap

SolBridge International School of Business / City University of Hong Kong

May 24, 2018

arXiv:1910.02144v1 [q-fin.GN] 20 Sep 2019

Keywords: Trading Strategy; Investment Hypothesis; Uncertainty; Trial and Error; Risk Management;

Volatility

JEL Codes: G11 Investment Decisions; D81 Criteria for Decision-Making under Risk and Uncertainty; C63

Computational Techniques

Contents

1 Abstract 2

2 To Trade or Not to Trade 2

3 Good Ideas, Bad Trades ... Ugly Risks 4

3.1 Models of Planes and Seesaws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

3.2 Efficient Assumptions, Rational Myths and Catch-22 Conundrums . . . . . . . . . . . . . . . 8

4 Sets of Strategies 11

4.1 Delta-One Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

4.2 Derivative Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

5 Beating Benchmarks by Building Bouncy Baskets 15

5.1 Sharpening the Sharpe Ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

5.2 Data Generation via Simulation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20

5.3 Simple Sample Ranking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22

6 Taming the Volatility Skew 27

7 A Happy Ending 29

8 End-notes 29

9 References 34

1
1 Abstract

This paper acts as a collection of various trading strategies and useful pieces of market information that might

help to implement such strategies. This list is meant to be comprehensive (though by no means exhaustive)

and hence we only provide pointers and give further sources to explore each strategy further. To set the

stage for this exploration, we consider the factors that determine good and bad trades, the notions of market

efficiency, the real prospect amidst the seemingly high expectations of homogeneous expectations from human

beings and the catch-22 connotations that arise while comprehending the true meaning of rational investing.

We can broadly classify trading ideas and client market color material into Delta-One and Derivative strategies

since this acts as a natural categorization that depends on the expertise of the various trading desks that will

implement these strategies. For each strategy, we will have a core idea and we will present different flavors of

this central theme to demonstrate that we can easily cater to the varying risk appetites, regional preferences,

asset management styles, investment philosophies, liability constraints, investment horizons, notional trading

size, trading frequency and other preferences of different market participants.

As an illustrative example, we consider in detail an investment strategy, titled “The Bounce Basket”, designed

for someone to express a bullish view on the market by allowing them to take long positions on securities that

would benefit the most from a rally in the markets. The central idea of this theme is to identity securities

from a regional perspective that are heavily shorted and yet are fundamentally sound with at least a minimum

buy rating from a consensus of stock analysts covering the securities.

2 To Trade or Not to Trade

We can broadly classify trading ideas or strategies (Pardo 2011; Nekrasov 2014; End-note 1) and market

color (Merkley, Michaely & Pacelli 2017; Cheng, Liu & Qian 2006; Groysberg, Healy & Chapman 2008;

Schipper 1991; Williams, Moyes & Park 1996; End-note 2, 3, 4) material into Delta-One and Derivative

strategies (generally, the price of Delta one securities have a one to one correspondence with the price of the

underlying: Natenberg 1994; Hull & Basu 2016; End-notes 5, 6), since this acts as a natural categorization

that depends on the expertise of the various trading desks that will implement these strategies. For each

strategy, we will have a core idea and it is very straight forward to present different flavors of this central

theme that can easily cater to the varying risk appetites, regional preferences, asset management styles,

investment philosophies, liability constraints, investment horizons, notional trading size, trading frequency

and other preferences of different market participants. Once we have some market color or a possible trading

idea, the conundrum seen in the title of this section presents itself, which is whether to implement it and

how exactly; we address some of these concerns through the rest of this article.

As the number of securities in any trading idea is varied, the error in the expected returns, the variance of

returns, the benefits of diversification and the liquidity constraints will vary (risk, return, diversification and

2
liquidity are discussed in: Bodie, Kane & Marcus 2014; Elton, Gruber, Brown & Goetzmann 2009). Hence,

it is important to consider different number of securities as different variations of the core strategy. The

costs of implementing the strategy will also vary with the number of securities and other parameters used to

create the strategy. Hence, it is important to explicitly calculate these figures for different variations of the

core strategy (for trading costs see: Perold 1998; Almgren & Neil 2001; Kashyap 2016b).

The Execution Risk and the Post Execution Portfolio risk of the strategy will depend on the Market Impact,

Market Risk and the Timing of the executions that make up the strategy (Kashyap 2016b). Ways to achieve

optimality in this regard are elaborated below in the “Risk and Best Execution Advisory” point 10. Any

investment firm that already has some of these trading strategies, can look for supplementary information

to improve the pre and post trading experience. Combination strategies (or cross-trading) is possible when

implementing two strategies reduces the overall market exposure and hence the risk of the blended strategies.

Also, in certain cases, once we implement one strategy, the additional cost and the risk to implement another

strategy, (marginal cost and risk) is significantly less and hence it is can be demonstrated that it is beneficial

to implement multiple strategies.

These ideas can be implemented mostly with data available from Bloomberg (Bloomberg 1981; End-note 7)

or other market data vendors. If additional information is required it is mentioned along with the specific

trading idea (we might be able to supplement any basic data set with specialized data sources). A statistical

tool like MATLAB (Window 2010; End-notes 8, 9; a basic database to maintain the time-series data and

other information would be a prudent investment as well) would be required to perform the regressions and

other computations to back-test (Bailey, Borwein, de Prado & Zhu 2014) the strategies, estimate the risk

and Profit and Loss (P&L) levels on these strategies. For the sake of brevity and to keep this document

simply as an overview of the possibilities, the computational complexities and implementation details have

been abstracted away from the individual strategy sections below. As it will become clear, the design and

implementation of these strategies will require personnel with quantitative skills and training in mathematics

as it applies to finance and economics, hence the title “The Benefits of Friendship with Quantitative Analysts

and Financial Engineers”.

This paper acts as a collection of various trading strategies and useful pieces of market information that might

help to implement such strategies. This list is meant to be comprehensive (though by no means exhaustive)

and hence we only provide pointers and give additional sources to explore each strategy further. To set the

stage for this exploration, we consider the factors that determine good and bad trades, the notions of market

efficiency, the real prospect amidst the seemingly high expectations of homogeneous expectations from human

beings and the catch-22 connotations that arise while comprehending the true meaning of rational investing.

We consider in detail an investment strategy, titled “The Bounce Basket” in section (5). This can be beneficial

when we expect the market to rebound after a slump or after a bad economic cycle. This strategy acts as a

3
complete numerical illustration of the general principles behind trading strategies discussed in sections (3; 4

).

3 Good Ideas, Bad Trades ... Ugly Risks

We can represent the investment process as a dotted circle since there is a lot of ambiguity in the various

steps involved. The circle also indicates the repetitive nature of many steps that are continuously carried out

while investing. If we consider the entire investment management procedure as being akin to connecting the

dots of a circle, then the Circle of Investment can be represented as a dotted circle with many dots falling

approximately on the circumference, but it hard to have an exact clue about the exact location of the center

or the length of the radius.

The Equity asset class holds the potential for unlimited upside and brings with it partial ownership of the

firm and hence some influence over the decision making process. It can be argued that this premise of

boundless profits, coupled with limited losses or liability and a certain degree of control, make this asset class

an extremely appealing one, contributing to its immense popularity. Hence, the strategies discussed below are

more immediately applicable to the stocks markets, but it is fairly straight forward to extend them to other

asset classes (for foreign exchange and fixed income securities, see: Copeland 2008; Tuckman & Serrat 2011).

The various asset classes can be compared to balloons tethered to the ground, with the equity balloon having

the weakest connections to the ground and also the weakest controls to guide it, if it is wind-borne. The lack

of a strong controlling factor also makes regime changes much harder to detect for equities (regime changes

are a major shift in the investment landscape: Wade 2008; Angeletos, Hellwig & Pavan 2007; Gasiorowski

1995).

We need to keep in mind that good traders can make bad trades and bad traders can make good trades, but

over many iterations, the good traders end up making a greater number of good trades and hence we provide

some distinctions between good and bad trades below (Kashyap 2014b).

1. The factors that dictate a good trade or a bad trade depend on the Time Horizon and the Investment

Objective. The time horizon can be classified into short term, medium term and long term. The

investment objective can be conservative or aggressive. While there are no strict boundaries between

these categories, such a classification helps us with the analysis and better identification of trades.

2. Any trade that fulfills the investment objective and time horizon for which it is made is a good trade.

Otherwise, it is a bad trade.

3. On the face of it, we can view good trades as the profitable ones and bad trades as ones that lose

money. But where possible, if we try and distinguish between proximate causes and ultimate reasons,

4
 it becomes apparent that good trades can lose money and bad trades can end up making money.

4. Due to the nature of uncertainty in the social sciences: the noise around the expected performance of

any security; our ignorance of the true equilibrium; the behavior of other participants; risk constraints

like liquidity, concentration, unfavorable Geo-political events; etc. implies we would have deviations

from our intended results. The larger the deviation from the intended results, the worse our trade is.

5. What the above implies is that, bad trades show the deficiencies in our planning (estimation process)

and how we have not been able to take into account factors that can lead our results astray. It is true

that due to the extreme complexity of the financial markets, the unexpected ends up happening and

we can never take into account everything. We just need to make sure that the unexpected, even if it

does happen, is contained in the harm it can cause. The good thing about bad trades is the extremely

valuable lessons they hold for us, which takes us through the loop or trials, errors and improvements.

6. We then need to consider, how a good trade can lose money. When we make a trade, if we know

the extent to which we can lose, when this loss can occur and that situation ends up happening, our

planning did reveal the possibility and extent of the loss, hence it is a good trade.

7. The bottom line is that, good trades, or bad trades, are the result of our ability to come up with

possible scenarios and how likely we think they will happen. The ability to visualize possible outcomes

is related to intelligence. Everything else being equal, someone with experience or someone who has had

the benefit of having participated in repetitions of similar situations and then having made decisions in

some cases after mistakes in earlier iterations (learning through trial and error: Ismail 2014; Kashyap

2017; End-note 10) will be better at facing uncertain situations and solving problems.

Zooming back into equities, the following are some other factors that can contribute to good equity trades.

1. The trade will not soak too much of the available liquidity, as measured by the average trading volume,

unless of course, we wish to take a controlling stake in the firm (Bernstein 1987; Pï¿œstor & Stambaugh

2003; Bhide 1993; Amihud 2002; Hameed, Kang & Viswanathan 2010).

2. It is held by a number of investors. There is more uncertainty if there are more investors, but it seems

to work to our benefit in most cases. If the number of investors is limited, the possibility of all of

them doing the opposite of what we want is higher and more likely (Amihud, Mendelson & Uno 1999;

Lakonishok, Shleifer & Vishny 1992; Chan & Lakonishok 1993; Gompers & Metrick 2001; Asquith,

Pathak & Ritter 2005; An & Zhang 2013).

5
 3. The noise or the randomness is less so that our decisions can be more accurate. This can be measured

by volatility or the price fluctuations that we see (French, Schwert & Stambaugh 1987; Schwert 1989;

Ang, Hodrick, Xing & Zhang 2006; Glosten, Jagannathan & Runkle 1993).

4. The firm issuing the securities is not too dependent on any particular product, profits from a particular

region, is not overburdened with debt, is paying dividends consistently, its price is not too high compared

to its earnings and other fundamental research indicators (Lancaster 1990; Spence 1976; Bilbiie, Ghironi

& Melitz 2012; Randall & Ulrich 2001; Srinivasan, Pauwels, Silva-Risso & Hanssens 2009).

5. If we are able to see some pattern in the share price changes, that is a good trade. This means that this

security is exhibiting Non-Markovian behavior (Turner, Startz & Nelson 1989; Hassan & Nath 2005;

Cai 1994; Hassan 2009; Litterman 1983). Such behavior is usually hard to detect, but it comes down

to the lens we are using to view the world or the methods we are using to perform historical analysis

(Hamilton 1994; Gujarati 2009; Verbeek 2008).

6. If the security is affected by any asset price bubbles and we are able to detect the formation of such

bubbles (Siegel 2003; Stï¿œckl, Huber & Kirchler 2010; Hott 2009; Andersen & Sornette 2004; Scherbina

& Schlusche 2014; Kashyap 2016a).

7. If we are shorting the security and it has a greater tendency for a downward movement, as exhibited by

its skew and other higher moments (Corrado & Su 1996; Bakshi, Kapadia & Madan 2003; Badrinath

& Chatterjee 1991; Badrinath & Chatterjee 1988; Chen, Hong & Stein 2001; Barberis, Mukherjee &

Wang 2016; Amaya, Christoffersen, Jacobs & Vasquez 2015).

8. So far, we have talked about the unknowns that we know about. What about the unknowns that we

don’t know about. The only thing, we know about these unknown unknowns are that, there must be

a lot of them, hence the need for us to be eternally vigilant (Taleb 2007).

3.1 Models of Planes and Seesaws

The analogy of, building a plane and flying it, to constructing a model and trading with it, will help us

consider the associated risks in a better way. Modeling would be the phase when we are building a plane,

and the outcome of this process is the plane or the model which we have built; trading would then be the

act of flying the plane in the turbulent skies, which are the financial markets. The modelers would then

be the scientists (also engineers) and the pilots would be traders. It is somewhat out of the scope of this

document to discuss questions regarding what kind of person can be good at both modeling and trading.

Trading would need a good understanding of what the model can do and where it will fall short; and building

6
a model will need to know the conditions under which an model has to operate and the sudden changes the

trading environment might encounter.

A deterministic world can be made to seem stochastic quite easily, since randomness is only from the point

of the viewer, the creator of uncertainty (also perhaps, the universe) has no randomness. Hence, it might

be possible to start with a few simple rules that makes sense intuitively and explain the stochastic behavior

of most phenomenon. Our investment decisions are made over time and so we set the direction of forward

movement in time to be equivalent to flying the plane forward. Since we cannot see what will happen in the

future; to fly the plane forward, we should not be able to see what is in front of us. This is equivalent to a

plane with the front windows blackened out. All we have are rear view mirrors (most planes don’t exactly

have rear view mirrors, but let us imagine our plane having one) and windows to the side.

As we are cruising along in time, what we have with us is the historical data or the view from behind and

real time data which is the view from the side, to aid in navigating our way forward or to the future. We use

the historical data to build our model and then use the data from the present to help us make forecasts for

what the future holds. The modeling would involve using data inputs to come up with outputs that can help

us decide which securities to pick, or to help set the direction of motion. The trading aspect would involve

using the model outputs and checking if that is the direction in which we want to be heading, that is actually

deciding which securities to pick, and watching out for cases where the predictions are not that reliable.

We can use multi-factor models (Hamilton 1994; Ng, Engle & Rothschild 1992) to decompose overall portfolio

risk and help identify the important sources of risk in the portfolio and link those sources with aspirations

for active return. We need to use the right principles, the right material and the right processes.

1. The right principles would require understanding certain concepts that determine the relevant measure

of risk for any asset and the relationship between expected return and risk when markets are tending

towards equilibrium. Examples for these are the Capital Asset Pricing Model (CAPM), the Arbitrage

Pricing Theory or other multi index models (Sharpe 1964; Ross 1976; Roll & Ross 1980; Bodie, Kane

& Marcus 2014).

2. The right material translates to having data on the security returns and choosing the relevant factors.

The amount of data and factors that is available is humongous. We need to use some judgment regarding

how much history to use. We also need to be attuned to significance and causality among the factors.

All this can involve some independent data analysis (Krejcie & Morgan 1970; Granger 1981; Adcock

1997; Hair, Black, Babin, Anderson & Tatham 1998; MacCallum, Widaman, Zhang & Hong 1999;

Lenth 2001).

3. The right process would mean using judicious concepts from econometric / statistical theory (Bishop,

7
 Fienberg & Holland 2007; Eisenbeis 1977). Some examples would be to check for the stationarity of

variables, to normalize the variables to scale them properly, to see if there is any correlation between

the independent variables and correcting for it (Multi-Collinearity: Hamilton 1994; Maddala & Lahiri

1992; End-note 11). We need to make sure no variables that would have an impact are left out (Omitted

Variable Bias: Hamilton 1994; End-note 12).

There needs to be a lot of tinkering; this means we need to have a continuous cycle of coming up with a

prototype, testing how it works and making improvements based on the performance. This is especially

important in the financial markets, since we are chasing moving targets as the markets have a tendency to

be quasi-equilibriums (we never know what a true equilibrium is but perhaps, the markets fluctuate between

multiple equilibriums, somewhat like a see-saw: Mantzicopoulos & Patrick 2010; Stocker 1998; End-note 13).

Modeling needs to be well thought out, with due regard to anticipating as many scenarios as possible and

building in the relevant corrective or abortive mechanisms when adverse situations occur. Given that, we are

never close to accomplishing a perfect model, which can handle all cases without failure and without constant

changes, we would need to constantly supervise the outcomes; hence models that are simple and robust are

better suited, since it is easier to isolate the points of failure when things get rough. Robust here means

producing similar results under a variety of conditions, with some changes to the inputs or the controls.

3.2 Efficient Assumptions, Rational Myths and Catch-22 Conundrums

A primary question that arises in finance is: whether markets are efficient? Questions & Answers (Q&A)

are important. But Definitions & Assumptions (D&A) are perhaps, more important. The good news is that,

Q&A and D&A might be in our very DNA, the biological one (Alberts, Johnson, Lewis, Raff, Roberts &

Walter 2002; End-note 14). Maybe, DNA hold the lessons from the lives of every ancestor we have ever

had. Evolution is constantly coding the information, compressing it and passing forward, what is needed to

survive better and to thrive, building what is essential right into our genes (Church, Gao & Kosuri 2012;

Lutz, Ouchi, Liu & Sawamoto 2013; Kosuri & Church 2014; Roy, Meszynska, Laure, Charles, Verchin & Lutz

2015).

The assumption made in finance regarding homogeneous expectations (Levy & Levy 1996; Chiarella & He

2001), especially in the derivation of the efficient frontier, the CAPM and the Capital Market Line (Bodie,

Kane & Marcus 2014), is stunningly sophisticated, yet seemingly simplistic. Most people would argue that

no two people are alike, so this assumption does not seem validated (Valsiner 2007; Buss 1985; Plomin &

Daniels 1987). Then again, this assumption is perhaps a very futuristic one, where we are picking the best

habits and characteristics, from our fellow beings (maybe not just humans?) and at some point in the future,

8
we might tend to have more in common with each other, fulfilling this great assumption, which seems more

of a prophecy. Again, if we become too similar then mother nature, or, evolution, will have less to work with;

since more differences tell her which characteristics are better for certain conditions and many possibilities

create stronger survival potential (Rosenberg 1997; Wilke, ... , & Adami 2001; Elena & Lenski 2003; Nei

2013). Too much similarity might not be an issue if survival is no longer a concern (Kashyap 2018). But

with respect to finance, we might evolve enough, so that one day, we might have the same expectations with

respect to our monetary concerns. This would also be the day when the Bid-Offer spread would cease to

matter, or, we would be indifferent to it, making every coffee shop, theater, street corner, pub, or everywhere

. . . a venue for any product (Kashyap 2015).

Hence if we vary our definitions of efficiency and the corresponding assumptions, a useful chain of thoughts

and efforts would be to capture, whether and how much, the actions of various players takes the markets

towards different forms of efficiency (Fama 1970). This implies a belief that different markets could have

different levels and forms of efficiencies over different times and understanding how the players are acting

could be useful to predict what information could be an advantage, depending on the efficiency that is believed

to be at work.

Perhaps, another way of looking at and understanding this concept is by pondering over the notion of a

rational investor, who has been defined in multiple ways and extensively discussed (also known in economic

circles as Homo Economicus: Persky 1995; Thaler 2000; End-note 15). Before we consider the Q&A / D&A

related to a rational investor, we state a simple game from game theory called “Guess 2/3 of the average”

(Nagel 1995; another related game is known as the Keynesian beauty contest: Keynes 2018; Bï¿œren, Frank

& Nagel 2012; Nagel, Bï¿œhren & Frank 2017; End-note 16). The objective of the game is for the participants

to guess what 2/3 of the average of the guesses of everyone participating in the game will be, and where the

numbers are restricted to the real numbers between 0 and 100, inclusive. The winner is the person whose

chosen number is closest to the 2/3 average of all chosen numbers and will obtain a fixed amount as a payoff

that is independent of the stated number and 2/3. If there is a tie, the prize is divided equally among all the

winners.

There is a unique Nash equilibrium (Nash 1951; Osborne & Rubinstein 1994; End-note 17) for this game

that can be found by iterated elimination of weakly dominated strategies. Suppose that all participants guess

the highest possible number, 100, then clearly the average of all the guesses will be 100. But to win, they

need to guess 2/3 of the average, hence their guess has to be 2/3*100, but if everybody has 2/3*100 as their

guess, they need to guess 2/3 of 2/3*100 or 2/3*2/3*100 and this process will continue. Continuing this

line of reasoning k times and as k gets larger and larger, that is as k → ∞, the guess g of any participant

gets closer and closer to zero. Alternately stated, the limiting value for the guess game, g, as the number

of iterations k increases, (as we continue our line of reasoning by taking the 2/3 of the maximum value that

9
someone can guess) is given by,
 k
2
g = lim ∗ 100 = 0 (1)
k→∞ 3

This game is usually played to demonstrate that few people, including students of economics and game

theory, actually get the equilibrium answer of zero (End-note 18). Hence if a rational participant is someone

who would want to win this game by making the right decisions and obtain the winning payoff, it is unclear

whether he should present the above equilibrium guess (Eq 1). This example illustrates that other than

the non-trivial mathematics expected from any rational participant, he is supposed to be anticipating what

everyone will do, which could include the possibility that not everyone participating might be fully rational.

Hence his winning guess might have to be different from the one shown in (Eq 1), making him do irrational

things unless he can not only read the minds of everyone but also force his will upon them to be rational.

To be rational he has make sure everyone acts rationally or he has to act irrationally: a Catch-22 situation

(Heller 1999).

In a similar vein, we can define a rational investor as someone who is not just factoring in the potential

investment decisions of every market participant, but is also having to ensure that everyone is making the

decisions that will be beneficial to him. In the above game, the decisions of everyone had to be the same, but

it could be different in many other situations, especially in the financial markets (we will not discuss further

the very stimulating topic of whether and how two different decisions can still be beneficial and rational to

the participants; but it would perhaps be proper material for a slew of papers and books). The message

for us is that either we all have to become rational investors or nobody can be a rational investor. Another

implication of this chain of thoughts is that if all of us become rational investors then our expectations might

become homogeneous, making markets efficient and validating the assumptions made to derive finance and

economic theories; though if that happens there might be no need for economics and finance at that point,

since we might have transcended beyond the need for wealth, wants and other worldly aspects: another

Catch-22 situation.

The computational challenge in this case was limited due to the rather simplified nature of the exercise.

But in other decision making situations encountered in daily life, the tools and theories of economics pre-

scribe solving complex optimization problems to arrive at the right results. If we ponder on the intellectual

requirements an agent has to possess to confront and navigate his daily challenges, it becomes clear that it

is beyond the capabilities of all humans to use such calculations in their everyday decisions. We want to

highlight here that some humans have created complex but wonderfully elegant solutions for many simple

everyday problems. But even after assuming that such a human would use the solution he has developed for

a particular problem, he would fail to adopt the solutions created by others for other problems he encounters

since he would have limited expertise with problems in another domain.

Clearly, another case is where we might not have developed a solution ourselves, but we have studied

10
the solutions of others extensively enough so that we are intimately familiar with it and using it has become

second nature to us. Even if we make the valid argument that many solutions are related and the marginal

effort to master a new solution is less once someone has good knowledge of a few solutions, we need to be

aware that there are too many new techniques and tools being introduced and the complexity in solutions is

increasing significantly. This issue of most of us not being familiar with most solutions is exacerbated with

the highly specialized nature of academic research being conducted and encouraged, coumpounded by the

artificial boundaries we have created by labeling disciplines. Many journals do state that they encourage

multi-disciplinary work but when confronted with work that truly transcends the fake silos of knowledge we

have created, editors and reviewers struggle to make the right decisions: (Ke, Ferrara, Radicchi & Flammini

2015 study how common , “sleeping beauties are in science”, papers whose relevance has not been recognized

for decades, but then suddenly become highly influential and cited; Gans & Shepherd 1994 find that journals

have rejected many papers that later became classics; this should make us aware of the possibility that many

papers are being rejected only because their contributions are not being realized).

We want to emphasize that these are unintended consequences due to the constraints placed on the

actual channeling of research efforts to knowledge creation and dissemination. One reason why such unwanted

outcomes creep up, despite the fact that journals, editors, scholarly associations and other research institutions

are wonderful innovations done with the honorable intention of helping us comprehend the cosmos around

us, is because we live in a world that requires around 2000 IQ points to consistently make correct decisions;

but the smartest of us has only a fraction of that (Ismail 2014; Kashyap 2017; End-note 10). Hence, we need

to rise, above the urge to ridicule, the seemingly obvious blunders of others, since without those marvelous

mistakes, the path ahead will not become clearer for us. Someone with 2000 IQ points is surely a super

hero, aptly named IQ-Man. So a rational investor is this mythical character called IQ-Man, who unlike

other super-humans like Super-Man does not even have a movie about him (for society’s fascination with

superheroes or super-humans see: Reynolds 1992).

4 Sets of Strategies

4.1 Delta-One Strategies

1. Index Re-balance

When an index is re-balanced, certain constituents are removed, added or their weights in the index

are changed. Many participants try to anticipate these changes and take positions depending on what

they expect to change in any index. Trading strategies and market color can be created indicating

expected inflow and outflow at a security level based on the expected weight change or depending

11
 on the re-balancing event (Kostovetsky 2003; Bloom, Gouws & Holmes 2000; Aked & Moroz 2015;

Chow, Hsu, Kalesnik & Little 2011). Basket Trading Ideas to take advantage of expected inflow and

outflow of Index Funds based on expected weights on the re-balance dates. We can use Index Tracking

(Beasley, Meade & Chang 2003; Guastaroba & Speranza 2012; Dose & Cincotti 2005; Stoyan & Kwon

2010) and Co-Integration (Alexander 1999; Engle & Clive 1987; Banerjee, Dolado, Galbraith & Hendry

1993; Harris 1995; Alexander & Dimitriu 2005a, b) principles to provide better estimates of the baskets

and capture a certain level of dollar flows. MSCI (Hau, Massa & Peress 2009; Chakrabarti, Huang,

Jayaraman & Lee 2005; End-note 19) indices are ideal set to start with and it is possible to extend it

to other indices with minor adjustments depending on the rules used for the re-balancing that could

differ among the many index providers. This strategy would need index membership information from

the relevant index providers. Please see Index Tracking and Co-Integration in points 4, 5

2. Macro Theme Baskets

Creation of stock baskets depending on Macro themes (Burstein 1999; Franci, Marschinski & Matassini

2001; Chen, Leung & Daouk 2003). Bounce Basket: Securities expected to benefit the most from

the rebound in the securities markets and the overall economy (section 5). Short Basket: Securities

that are expected to show a significant fall due to fundamental weakness and an overall drop in the

market. Securities that perform the best during upward expected Inflationary moves. Securities that

perform the best during upward movement of Oil Prices, Gold Prices or other commodities. Regional

baskets that can best cater to investors looking for regional exposure. These baskets are identified by

performing a factor analysis (principal component analysis or regressions can also be used: Hamilton

1994; End-note 20) of historical security prices and other factor indicators (Ludvigson & Ng 2007;

Jolliffe 1986; Shlens 2005; Costello & Osborne 2005). We can use Index Tracking and Co-Integration

principles to provide better estimates of the baskets. Please see Index Tracking and Co-Integration in

points 1, 4, 5. Macroeconomic data-sources would be required for this set of trading ideas.

3. Sector Theme Baskets

These set of strategies are aimed at capitalizing on expected sector rotations. Depending on various

macroeconomic developments and business cycle trends, different sectors are expected to be either

bullish or bearish. We can create baskets of stocks to benefit most from these expected trends. It

is possible to put a regional spin on each of the baskets below. We can customize this for different

durations of the trades and different notional amounts. We can use Index Tracking and Co-Integration

principles to provide better estimates of the baskets. Please see Index Tracking and Co-Integration in

12
 points 1, 4, 5. Sector specific data-sources would be required for this set of trading ideas.

The following are some of the sector theme baskets.

• Gaming (Casino) Basket

• Real Estate Basket

• Technology Basket

• Financials Basket

• Utilities Basket

• Travel and Luxury Hotels Basket

4. Index Tracking Baskets

We can customize this based on two characteristics. Create baskets of stocks to track the index with

the least tracking error and a desired number of stocks. Produce a certain amount of tracking error and

select the number of stocks required to achieve this level of tracking error. Please see Index Tracking

and Co-Integration references in point 1.

5. Co-Integration Baskets

Pairs Trading Ideas are based on two portfolios (or even individual securities: Miao 2014) of stocks

which have moved together historically, but are now in diverging positions, so we expect them to

converge back. This is easily implemented for pairs of securities in the same sector. Please see Index

Tracking and Co-Integration references in point 1.

6. Portfolio Risk Basket

Many sell side desks take on principal positions (commit their own capital instead of acting just as an

intermediary) on baskets of stocks that are opposite to client trades. A basis point quote is provided

to the client based on the market impact to enter the positions, to exit the positions, volatility of the

security prices, expected duration to enter the position, expected duration to exit the position and

transaction costs. Inventory Management techniques (Lancioni & Howard 1978; Blackstone Jr & Cox

1985) will need to be used to manage the overall exposures on the desk that is creating this strategy

and this will be incorporated into the basis point pricing of the risk basket.

13
 7. Index Arbitrage Trading Ideas

Arbitrage between the prices of index constituents and the corresponding futures contracts (Chung

1991; Dwyer Jr, Locke & Yu 1996; Kumar & Seppi 1994; Nandan, Agrawal & Jindal 2015; Fung, Lau

& Tse 2015). We will need to consider the effect of stock commissions and futures commissions on

the profitability of the trades. We can provide early close out options as opposed to close out on the

expiration date. We will need to consider the market impact of the stock transactions on the stock

price when we put on the trade and the effect of the same if we do an early close out.

8. Rich / Cheap Analysis based on Stock Beta

We can create baskets of under-priced and overpriced securities based on the Beta of individual securities

versus different indices acting as a proxy for the market (Black 1992; Isakov 1999; Amihud & Mendelson

1989; Fletcher 2000).

9. Equity Swap Baskets

In certain markets, most investors do not have access to trade the securities and the only way to get

access to these markets is through swaps from a registered broker (Kijima & Muromachi 2001; Gay,

Venkateswaran, Kolb & Overdahl 2008; Chance & Rich 1998; Wang & Liao 2003; Wu & Chen 2007;

End-note 21). We can create swap baskets to pick up exposure for the above themes; also swap baskets

can be created for the other markets as well, since it could be a good alternative to trading all the other

investments.

10. Risk and Best Execution Metrics

We can create risk metrics to supplement the information on trade execution in terms of market impact,

market risk and optimal timing of transactions (Smithson 1998; Bouchaud & Potters 2003; Wipplinger

2007; Christoffersen 2012). It would be helpful to collect information on the market impact of individual

transactions or portfolios based on the timing requirements of implementing the strategies. This market

impact can be calibrated to the orders, executions and the skill of the executions teams within the firm

so that it will capitalize on the trading advantages possessed by the firm. Such information can not

only help with the planning of optimal execution strategies to reduce the market impact and market

risk of the resulting portfolio, but can be useful to check if the trading strategy is viable; since even

though it promises to produce good returns but implementing it might eat away the returns. Optimal

execution will be in terms of the number of pieces the overall basket will be broken into and the duration

14
 and timing over which to trade the individual pieces. Portfolio risk monitoring will be needed for the

individual strategies and changes in risk levels will need to be monitored for different increments /

decrements to the various trading strategies.

4.2 Derivative Strategies

To implement these, we would need some derivatives pricing and risk modules, a basic level of which can

be implemented in MATLAB. Since the number of combinations of derivative instruments is huge, only a

brief overview is provided below. Depending on the specifics of the instruments and the market conditions,

various strategies can be implemented.

1. We can have trades on index options and options on the constituents based on the volatility of the

individual securities and the volatility level of the index and the correlation between individual security

pairs and the average level of correlation in the basket. These are known as volatility and dispersion

Trades (Marshall 2009; Meissner 2016; Driessen, Maenhout & Vilkov 2009);

2. We predict volatility levels using ARCH / GARCH models and trade instruments that are theoretically

mispriced when compared to the implied volatility levels (Andersen, Bollerslev, Diebold & Labys 2003;

Andersen & Bollerslev 1998; Engle & Ng 1993; Xu & Malkiel 2003; Bollerslev, Chou & Kroner 1992;

Nelson 1991).

3. Put – Call Parity violations (Cremers & Weinbaumv 2010; Klemkosky & Resnick 1979; Finucane 1991),

combined with either implied volatilities or based on predicted ARCH / GARCH volatility levels, can

be used to find undervalued or overvalued instruments and appropriate strategies can be constructed.

4. Option hedges are possible for basket trades constructed in the delta one section 4.1.

5. Structures based on different options, that is structured equity derivatives (Kat 2001) suitable for

different Macro, Sector themes and Expectations.

5 Beating Benchmarks by Building Bouncy Baskets

The “Bounce Basket” is designed for someone to express a bullish view on the market by allowing them

to take long positions on securities that would benefit the most from a rally in the markets. The central

idea of this theme is to identity securities from a regional perspective that are heavily shorted and yet are

fundamentally sound (Summers 1986; Dechow, Hutton, Meulbroek & Sloan 2001; Bakshi & Chen 2005) with

15
at least a minimum buy rating from a consensus of stock analysts covering the securities (Barber, Lehavy,

McNichols & Trueman 2001; Barber, Lehavy, McNichols & Trueman 2003; Brown, Wei & Wermers 2013).

The most heavily shorted securities are obtained from a top shorts ranking model (Kashyap 2017b). To

outline the intuition behind such a ranking, suppose we wanted to rank the most livable city in the world (or

let us say, the best soccer player in history). We would identify characteristics that might be useful to make

such an assessment. We would weight the individual characteristics and then collect data for the entities that

are being ranked. We could then calculate an overall score, (an aggregation based on the collected data and

corresponding weights), which would then yield a suitable ranking; since, having one number for each object

we are interested in, facilitates a ranking.

Once a ranking is formed, we could use some of the factors as the criteria for exclusion from the finalized

standings. These factors act as filters to remove securities from the overall universe of stocks in a region (say

Asia) based on specific levels of the parameters. Again, to outline the intuition here: a city could rank very

well on most factors, but could be below acceptable standards in one factor, (say air quality), requiring that

it be removed from the final ranking; and hence certain securities would be excluded from the final basket.

Below we discuss some of the factors that can be helpful towards forming such a ranking from a securities

lending perspective, the rationale behind their usage to create the ranking and also provide contextual and

numerical pointers that could be used to implement the filtering mechanism.

1. Short Interest (SI) - The short interest is the amount of shares shorted in a security by all market

participants (best be expressed in USD so it is normalized across securities and also when dealing with

multi-market regions like Asia), and is clearly a direct indicator of investors wishing to express negative

sentiment on that stock. Only securities with Short Interest of more than a certain USD value (say 10

million) are considered for inclusion into the basket. An adjustment is made to factor in the relative

size of the markets. This would mean that for two securities with say short interest of 11 million USD,

one from Japan and one from Taiwan, the Taiwan security would get ranked higher since the stock loan

market for Japan is higher and the levels of short interest are much higher for Japanese stocks (Asquith,

Pathak & Ritter 2005; Kashyap 2016c; Bris, Goetzmann & Zhu 2007; SI can also be expressed as a

ratio: End-note 22; but using the actual share amount makes for a more granular ranking and generally

traders want to know how many shares are shorted compared not just to the float amount, but the

supply they can obtain from other lenders. Also the loan rates are higher when the short interest

compared to the float is higher, so another factor captures the effect of this ratio. The SI ratio is also

included as a separate factor referred to below as the Days to Cover).

2. Loan Rates (LR) - The most important variable that indicates how heavily shorted a security is, is the

loan rate. Only securities with annual loan rates greater than a threshold (say, 1.5%) are considered.

16
 An adjustment is done to factor in the maximum level of loan rates in each market similar to point 1

above. A lending desk has at-least two flavors of these loan rates (a rate at which the desk is able to

source inventory and another rate which is slightly higher since it is the rate at which loans are made

to end investors).

3. Days To Cover (DT C) - Days to cover (also known as the Short Interest Ratio; (Hong, Li, Ni,

Scheinkman & Yan 2015; End-note 22) is a measurement of a company’s issued shares that are cur-

rently shorted, expressed as the number of days required to close out all of the short positions. It is

calculated by taking the number of shares that are currently shorted and dividing that amount by the

average daily volume for the shares in question. For example, if a company has average daily volume

of 1 million shares and 2 million shares are currently short sold, the shares have a cover rate of 2 days

(2M/1M). A higher value for this metric indicates that if investors wish to cover their shorts, it could

take many days and during that time, their positions could end up losing money significantly. Only

securities requiring more than a certain days to cover, (say, 4) are considered.

4. Loan Balance Growth (LBG) - The loan balance is a notional amount (measured in USD) and represents

the total amount of loans being made by a particular broker or short selling desk. Hence, growth in

this amount (expressed in percentage terms), captures the increase in the short sentiment being seen

by this participant. This information is sometimes shared with clients who are interested in trading

with the desk. Only securities with loan balance growth of more than a certain percentage, (say 25%)

over the past few months are considered.

5. Inverse Loan Availability (ILA or Loan Availability, LA) - The availability is the amount of shares that

could be possibly borrowed towards putting on additional short positions. It is the amount available

for shorting but currently unused. The inverse of this number (normalized by expressing in USD) is

used as contribution factor towards a total score, since lower this amount, greater the pressure on loan

rates and a higher indication that a particular security is heavily shorted. Only securities with loan

availability below a certain threshold are considered (say 10 million USD) are considered.

6. Liquidity (L) - We consider the average daily trading volume to ensure that once a basket is constructed,

we have enough volume being traded so that we can implement this strategy without liquidity problems.

Only securities that had a 20 day average trading volume (ADV) of more than a certain figure (say, 25

million USD) are considered.

7. Buy Rating (BR) - Only securities with a minimum buy rating from a consensus of analysts covering

the stocks are considered. The rationale behind this is that, as markets rebound, the securities that

17
 are fundamentally sounds are the ones that will receive positive inflows and trend up higher. Securities

that have problems with their operations are likely to remain in the negative investor sentiment zone,

or stay shorted.

8. High Beta (HB) - The securities with a relatively high beta in comparison to the market are chosen

so that they are geared to capitalize the most from any upward movement in the overall market. Only

Securities with Beta more than a certain value (say, 1.2) are considered.

The factors related to securities lending(SI, LR, DT C, LBG, ILA) and the liquidity(L) are technical in nature

(they have a time series that changes quite often) and hence they are further checked for stability and changes

over time by looking at the moving average and volatility of the particular factor over the last few (two or

three) months. Securities with a higher moving average are ranked higher and securities with higher volatility

are ranked lower. Additional factors such as the total number of lenders, the number of total shares available

for securities loans, etc. can be included. The weights are estimated using a trial and error (Ismail 2014;

Kashyap 2017c; End-note 10) approach so that the profitability of the securities chosen from a securities

lending perspective over a historical period are maximized. The rationale for such a weighting scheme is

that, a security is the most shorted security, if it was creating significant profits for the trading desk. One

sample model for the overall scoring mechanism can be summarized as below in (Eq: 2):

n
X
Total Score = wi fi = wsi SI + wlr LR + wdtc DT C + wlbg LBG + wila ILA (2)
i=1

+ Factors to capture moving average and volatility of individual variables (3)

Here, n is the total number of factors, fi (4)

wi are the weights of the individual factors (5)

n
X
Also, wi = 1 (6)
i=1

5.1 Sharpening the Sharpe Ratio

A key issue with the above scoring mechanism is the subjectivity of the weights and the necessity of having

to constantly tweak them. A significant amount of effort is involved to ensure that the weights are closely

aligned with the drivers of the P&L. As an alternate to the above scoring mechanism (that is a separate

aggregation of a number of factors weighted subjectively), we could use a single numeric indicator similar

to the Sharpe ratio, SR (Sharpe 1966; 1994; End-note 23). The SR combines the risk, (σr , the standard

18
deviation of returns), and return, (E (r), the expected return or an estimate based on historical returns), of

each individual asset or portfolio to give one number that contributes to a ranking. The return figure used

is the return of the asset in excess of a certain threshold, which is usually the risk free rate, rf , but it could
E(r)−rf
be the return on any other benchmark security (SR = σr ). This ensures that assets providing returns

below the threshold have a negative score and are relegated towards the bottom of the ranking. A similar

score can be created based on the loan rates and the corresponding standard deviation as shown in (Eq: 7),

E (LR) − rf
Short Score One = (7)
σLR

If the loan rates are below the risk free rate (or another higher threshold), any loans made on those securities

are not contributing much to bottom-line (to obtain those shares we would need to borrow money at the

risk free rate but we only earn back less than that), though many lending desks need to make loans in these

positions (or bundle it up with other securities as collateral for other positions; Sakurai & Uchida 2014;

Duffie, Scheicher & Vuillemey 2015; Fuhrer, Guggenheim & Schumacher 2016; End-note 24) since other

trading desks within the firm could be long those stocks. Given their low contribution to the P&L, these

securities are not to be placed in the top short ranking, irrespective of the values of other factors. Figure 1

can help us to understand why we need the minimum loan rate threshold and why just the ratio of return

to risk is not enough. Security BBB with an expected loan rate, E (LR) = 5.00, and a loan rate standard

deviation, σLR = 2.00, ranks higher than security CCC with E (LR) = 8.00 and σLR = 4.00 when we consider

just the ratio of expected loan rate and loan rate standard deviation, E (LR) /σLR . This issue is fixed and

security CCC is ranked higher than BBB when we consider the excess loan rate or loan rate premium divided

by the loan rate standard deviation, [E (LR) − rf ] /σLR to obtain a score.

Figure 1: Ranking with and without Rate Threshold

We could extend the above short score (Eq: 7) to include the short interest, loan availability, days to

cover and the loan balance growth to get the formulations shown in (Eqs: 8, 9, 10).

  
ξ (SI) E (LR) − rf
Short Score Two = (8)
ξ (LA) σLR

      
SI ξ (SI) E (LR) − rf ξ (SI) E (LR) − rf
Short Score Three = ≡ {DT C} (9)
ADV ξ (LA) σLR ξ (LA) σLR
    
LBt ξ (SI) E (LR) − rf
Short Score Four = (DT C) (10)
LBt−N ξ (LA) σLR

19
Due to the multiplication of factors, the loan balance growth is better represented as the ratio of the loan

balance (instead of in percentage terms, which is suitable for a summation) at the end and start of the

time period under consideration (a higher ratio, indicating an increase in the loan balance contribution to a

higher score and vice versa, LBG = LBt /LBt−N ). Here, LBt is the loan balance at time t;ξ () represents

the moving average function applied over the last few (two or three) months. Without taking the moving

average, the ranking would be sensitive to daily changes and might change quite drastically from day to day.

Scores based on the moving average are more stable, hence depending on the trading strategy (whether we

are re-balancing the portfolio on a weekly basis or once in a few months), we can choose, either the moving

average or the values on a particular day.

Other extensions could use a SR type score for each variable and combine it with the other variables.

Instead of the risk free rate, we would need to use a suitable cutoff point for the other variables, such that

when the variable drops below that point, it gets taken out of the top ranking (by having a negative score).

We need to pay attention while combining such ratios since if more than two variables have a negative value

and they are multiplied together, the resultant score could still be positive.

5.2 Data Generation via Simulation

The bounce basket (and other such baskets) can be created by various sell side brokers for buy side firms.

Having an idea of how such baskets are created (including the factors used based on the discussion above)

can lead to meaningful discussions between the two parties that want to participate in such a scheme and be

immensely useful towards maximizing the benefits of such a strategy. The data-set required for an in-house

flavor of the above idea, for risk monitoring or fine tuning the parameters, can be obtained by any investment

firm from the securities lending desks of their prime brokers (Hildebrand 2007; Melvin & Taylor 2009; Jacobs

& Levy 1993; End-note 25).

As noted earlier, given the number of random variables involved (and hence the complexity of the system),

a certain amount of computational infrastructure would be necessary. A typical securities lending desk can

have loan positions on anywhere from a few hundred to upwards of a few thousand different securities and

many years of historical data. It is therefore, a good complement to build some intelligence (software routines

that automatically run daily using data received from broker firms) that utilizes the historical time series

and calculates the short score from the corresponding formulae derived in section 5.1 without the need for

too many ongoing changes.

To demonstrate how this technique would work, we simulate the historical time series. Also, a typical

investment firm (as opposed to the intermediary, who would have all the above information) is unlikely to have

access to the full historical time series (but might have the time series of loan rates, prices, trading volume and

availability) and hence could simulate the variables for which the historical data is absent, as shown in this

20
section, to come up with a short score. We create one hundred different hypothetical securities and we come

up with the time series of all the variables involved (Price, Availability, Short Interest, Trading Volume, Loan

Rate, Alternate Loan Rate) by modelling them as Geometric Brownian motions with uncertainty introduced

via sampling from suitable log normal distributions ((Eqs: 11, 12; see, Norstad 1999 for normal, log normal

distributions; Hull & Basu 2016 provide an excellent account of using geometric Brownian motions to model

stock prices and other time series that are always positive). It is worth noting, that the mean and standard

deviation of the time series are themselves simulations from other appropriately chosen uniform distributions

(Figure 2). Some of the above variables can be modeled as Poisson distributions or simply consider them as

the absolute value of a normal distribution with appropriately chosen units. As an example, we model the

Loan Balance process as a folded normal distribution or by taking the absolute value of a normal distribution.

The mean and standard deviation of the loan balance distribution for each security are chosen from another

appropriately chosen uniform distribution.

dSit
Geometric Brownian Motion ≡ = µSi dt + σSi dWtSi (11)
Sit

WtSi ⇐⇒ Weiner Process governing Sith variable. (12)

Alternately, Sit ∼ N µSi , σS2 i , Absolute Normal Distribution

(13)

The simulation seed is chosen so that the drift and volatility we get for the variables are similar to what

would be observed in practice. For example in Figure 2, the price and rate volatility are lower than the

volatilities of the availability and other quantities, which tend to be much higher; the range of the drift

for the quantities (share amounts) is also higher as compared to the drift range of prices and rates. This

ensures that we are keeping it as close to a realistic setting as possible, without having access to an actual

historical time series. The volatility and drift (mean and standard deviation for the loan balance process) of

the variables for each security are shown in Figure 3. The length of the simulated time series is a little longer

than one year or 252 trading days for each security. A sample of the time series of the variables generated

using the simulated drift and volatility parameters is shown in Figure 4. The full time series shown below is

available upon request.

21
 Figure 2: Simulation Seed

Figure 3: Simulation Sample Distributions

Figure 4: Simulation Sample Time Series

5.3 Simple Sample Ranking

We provide three flavors of the short scores of the securities based on the 60 day moving average of the

variables, the values on the first day and the values on the last day of the sample in (Figures 5, 6, 7) corre-

spondingly. Under each of the three flavors, we consider all four formulations of the short scores mentioned

in section 5.1. Comparing the scores on the first day and last day should give us an idea of how the scores

22
(and hence the ranking) can change over the duration of a few months. Also, availability can be zero for

certain securities, leading to a error in the score calculation (divide by zero error), which is avoided in many

cases by using a moving average. Since our scores are based on a simulation we see some low loan rates,

low availability and high short interest numbers. In general, low availability and high short interest will be

reflected in higher loan rates. Similarly high loan rates, high availability and low short interest rarely occur

in practice. The days to cover generally does not include the moving average of the short interest, but we

use the moving average only for the flavor in Figure 5.

Securities with negative events in terms of credit rating downgrades, earnings downgrades, ongoing litigation

or the commencement of new litigation, failure to close a major deal, loss of a significant customer etc., are

removed on a case by case basis. The source for this information can be market data vendors or credit rating

companies. This step is included as a fail-safe procedure since the analyst rating filters and short factors we

have in place would remove most of these securities. The securities in the basket are weighted based on a

combination of their top shorts ranking and market capitalization with a maximum weight of 10% for any

single security. Baskets are constructed using the same concept for different historical periods when there is

an upward rally and the bounce basket is found to outperform the broader market at a statistically significant

level (the level can vary).

The initial ranking of top shorts is ideally done over a large universe and the final basket will need around a

couple of dozen stocks and hence filters need to be chosen to narrow down the original list. We can remove a

certain percentage of securities from the bottom (say 20%) from this ranked set of securities and additional

filters can be applied (sector, market capitalization, etc.) to further narrow down the constituents of the

basket. Some details about how filters can be applied are provided in the explanation of the factors and

the selection methodology above. Some of the markets on which empirical tests were tried include Japan,

Hong Kong, Taiwan, Korea, Singapore, Thailand, Indonesia and Malaysia. Custom baskets for each market

or even for individual sectors can be created based on the same selection model.

23
Figure 5: Short Scores - 60 Day Moving Average

24
Figure 6: Short Scores - First Day of Sample

25
Figure 7: Short Scores - Last Day of Sample

26
6 Taming the Volatility Skew

One of the main drawbacks of volatility is that it fails to capture the effect of changes in the direction in

the time series of any variable. This is because both rising or falling prices still have volatility and if we are

long a security, upwardly mobile prices could get penalized in any portfolio management decisions. (Figures

8, 9, 10) illustrate this limitation of using volatility. In all three figures, we compare two variables with

different time paths, but which offer the same net return over the time period under consideration. In Figure

8, variable one and variable two both have a steady upward path (not a single down movement), but variable

two which has a higher volatility ends up having a lower return to volatility ratio (return to risk ratio, if

volatility is used to measure risk) and could get underrepresented in a portfolio in comparison with variable

one; clearly a sub-optimal outcome. Likewise, in Figure 9, variable two has lower volatility but has falling

prices for sometime, when compared to variable one, which does not have a single fall in price. Lastly, in

Figure 10, variable one is falling more steadily than variable two, but variable one has greater volatility and

hence can be seen as better than variable two from a return to volatility perspective. These examples show

that volatility is not the most conducive metric to represent risk.

A key improvement in all the strategies discussed would be some method to factor in the effect of changes in

the upward or downward movements of a variable over time, since such directional changes could be either

beneficial or detrimental to our trading position, depending on whether we are long or short. This would be

especially important for the purpose of creating any ranking, which is central to the bounce basket, since we

would need to know how steady the changes in a variable are, in terms of whether it is trending upwards or

downwards. For this, a specially developed factor called the time weighted arrival deviation (Kashyap 2017a)

can be used as a metric to measure the path taken by the variable to arrive at the current value over the last

few months. To articulate the intuition, any security that had steady upward growth is ranked higher than

a security with similar growth but more ups and downs (or change in direction) in the path. Similarly, any

security that had steady downward growth is ranked lower than a security with similar downward growth

but with more changes in direction in the path. In short, securities are penalized for having ups and downs

in their price process, but unidirectional jumps in the direction of intended movement (if our position is long

then we want the price to go up) suffer no such penalty.

27
Figure 8: Limitations of Volatility

Figure 9: Limitations of Volatility

28
 Figure 10: Limitations of Volatility

7 A Happy Ending

We have looked at a number of delta-one and derivative trading strategies, related market color and pointers

to practically implement these investment ideas. We have discussed in detail a trading strategy, called the

bounce basket, for someone to express a bullish view on the market by allowing them to take long positions

on securities that would benefit the most from a rally in the markets. The advantages of investing in a

moderate amount of computing infrastructure and hiring personnel with technical abilities were illustrated in

terms of having a wider choice of investment alternatives, increased returns and better management of risky

outcomes. Given the dynamic nature of the financial markets, it would be practical to have a feedback loop

that changes the parameters of the strategy depending on changes in market conditions (Kashyap 2014a).

8 End-notes

1. Trading Strategy, Wikipedia Link In finance, a trading strategy is a fixed plan that is designed to

achieve a profitable return by going long or short in markets. The main reasons that a properly

researched trading strategy helps are its verifiability, quantifiability, consistency, and objectivity. For

every trading strategy one needs to define assets to trade, entry/exit points and money management

rules. Bad money management can make a potentially profitable strategy unprofitable.

2. Market Color is a word commonly used on trading desks both on the buy side and sell side (End-notes

3, 4). It refers to information regarding the financial markets, many times changes in variables that are

29
 deemed relevant to make trading decisions. The sell side provides many such pieces of information to

the buy side, eventually hoping to get trades done on the back of this such material. This could also

be considered as research done by analysts on both the sell side and the buy side.

3. Sell Side, Wikipedia Link Sell side is a term used in the financial services industry. The three main

markets for this selling are the stock, bond, and foreign exchange market. It is a general term that

indicates a firm that sells investment services to asset management firms, typically referred to as the

buy side, or corporate entities. One important note, the sell side and the buy side work hand in hand

and each side could not exist without the other. These services encompass a broad range of activities,

including broking/dealing, investment banking, advisory functions, and investment research.

4. Buy Side, Wikipedia Link Buy-side is a term used in investment firms to refer to advising institutions

concerned with buying investment services. Private equity funds, mutual funds, life insurance compa-

nies, unit trusts, hedge funds, and pension funds are the most common types of buy side entities. In

sales and trading, the split between the buy side and sell side should be viewed from the perspective of

securities exchange services. The investing community must use those services to trade securities. The

"Buy Side" are the buyers of those services; the "Sell Side", also called "prime brokers", are the sellers

of those services.

5. Delta One, Wikipedia Link Delta One products are financial derivatives that have no optionality and

as such have a delta of (or very close to) one – meaning that for a given instantaneous move in the

price of the underlying asset there is expected to be an identical move in the price of the derivative.

Delta one products can sometimes be synthetically assembled by combining options.

6. Derivative (finance), Wikipedia Link In finance, a derivative is a contract that derives its value from

the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate,

and is often simply called the "underlying." Derivatives can be used for a number of purposes, including

insuring against price movements (hedging), increasing exposure to price movements for speculation or

getting access to otherwise hard-to-trade assets or markets.

7. Bloomberg, Wikipedia Link Bloomberg L.P. is a privately held financial, software, data, and media

company headquartered in Midtown Manhattan, New York City. It was founded by Michael Bloomberg

in 1981, with the help of Thomas Secunda, Duncan MacMillan, Charles Zegar, and a 30% ownership

investment by Merrill Lynch.

8. Matlab, Wikipedia Link MATLAB (matrix laboratory) is a multi-paradigm numerical computing en-

vironment and proprietary programming language developed by MathWorks. MATLAB allows matrix

manipulations, plotting of functions and data, implementation of algorithms, creation of user interfaces,

30
 and interfacing with programs written in other languages, including C, C++, C#, Java, Fortran and

Python.

9. Statistical Software, Wikipedia Link Statistical software are specialized computer programs for analysis

in statistics and econometrics.

10. Nassim Taleb and Daniel Kahneman discuss Trial and Error / IQ Points, among other things, at the

New York Public Library on Feb 5, 2013. As Taleb explains, “it is trial with small errors that are

important for progress”. The emphasis on small errors is especially true in a portfolio management

context, since a huge error could lead to a blow up of the investment fund. (Ismail 2014) mentions the

following quote from Taleb, “Knowledge gives you a little bit of an edge, but tinkering (trial and error)

is the equivalent of 1,000 IQ points. It is tinkering that allowed the industrial revolution”.

11. Multicollinearity, Wikipedia Link In statistics, multicollinearity (also collinearity) is a phenomenon in

which one predictor variable in a multiple regression model can be linearly predicted from the others

with a substantial degree of accuracy. In this situation the coefficient estimates of the multiple regression

may change erratically in response to small changes in the model or the data. Multicollinearity does

not reduce the predictive power or reliability of the model as a whole, at least within the sample data

set; it only affects calculations regarding individual predictors. That is, a multivariate regression model

with collinear predictors can indicate how well the entire bundle of predictors predicts the outcome

variable, but it may not give valid results about any individual predictor, or about which predictors

are redundant with respect to others.

12. Omitted-variable bias, Wikipedia Link In statistics, omitted-variable bias (OVB) occurs when a sta-

tistical model leaves out one or more relevant variables. The bias results in the model attributing the

effect of the missing variables to the estimated effects of the included variables. More specifically, OVB

is the bias that appears in the estimates of parameters in a regression analysis, when the assumed spec-

ification is incorrect in that it omits an independent variable that is correlated with both the dependent

variable and one or more of the included independent variables.

13. Seesaw, Wikipedia Link A seesaw (also known as a teeter-totter or teeterboard) is a long, narrow board

supported by a single pivot point, most commonly located at the midpoint between both ends; as one

end goes up, the other goes down.

14. DNA, Wikipedia Link Deoxyribonucleic acid (DNA) is a molecule composed of two chains that coil

around each other to form a double helix carrying the genetic instructions used in the growth, de-

velopment, functioning, and reproduction of all known living organisms and many viruses. DNA and

31
 ribonucleic acid (RNA) are nucleic acids; alongside proteins, lipids and complex carbohydrates (polysac-

charides), nucleic acids are one of the four major types of macromolecules that are essential for all known

forms of life.

15. Homo Economicus, Wikipedia Link The term homo economicus, or economic man, is a caricature of

economic theory framed as a "mythical species" or word play on homo sapiens, and used in pedagogy.

It stands for a portrayal of humans as agents who are consistently rational and narrowly self-interested,

and who usually pursue their subjectively-defined ends optimally.

16. Keynesian Beauty Contest, Wikipedia Link. Keynes described the action of rational agents in a market

using an analogy based on a fictional newspaper contest, in which entrants are asked to choose the six

most attractive faces from a hundred photographs. Those who picked the most popular faces are then

eligible for a prize. A naive strategy would be to choose the face that, in the opinion of the entrant, is

the most handsome. A more sophisticated contest entrant, wishing to maximize the chances of winning

a prize, would think about what the majority perception of attractive is, and then make a selection

based on some inference from his knowledge of public perceptions. This can be carried one step further

to take into account the fact that other entrants would each have their own opinion of what public

perceptions are. Thus the strategy can be extended to the next order and the next and so on, at each

level attempting to predict the eventual outcome of the process based on the reasoning of other rational

agents. Keynes believed that similar behavior was at work within the stock market. This would have

people pricing shares not based on what they think their fundamental value is, but rather on what they

think everyone else thinks their value is, or what everybody else would predict the average assessment

of value to be.

17. Nash Equilibrium, Wikipedia LinkIn game theory, the Nash equilibrium, named after American math-

ematician John Forbes Nash Jr., is a solution concept of a non-cooperative game involving two or more

players in which each player is assumed to know the equilibrium strategies of the other players, and no

player has anything to gain by changing only their own strategy.

18. Experimental Results of Guess 2/3 of the average, Wikipedia LinkWe have tried more than ten trials

of this game as a classroom experiment with students of economics and finance. The number of

participants varied from 25 to around 60. When the number of participants were large, the students

were asked to provide their answers in teams of three or four so that the total number of answers were

usually between 15 to 20. This was done only to reduce the overhead later in finalizing the results. The

students played the game to obtain a certain advantage in their final score for the course. The winning

guess has usually been between 20 to 30. An interesting note is that when the team size is more than

32
 one, it leads to a lower guess.

19. MSCI, Wikipedia Link MSCI Inc. (formerly Morgan Stanley Capital International and MSCI Barra),

is a Global provider of equity, fixed income, hedge fund stock market indexes, and multi-asset portfolio

analysis tools. It publishes the MSCI BRIC, MSCI World and MSCI EAFE Indexes. The company is

currently headquartered at 7 World Trade Center in Manhattan, New York City, U.S.

20. Factor Analysis, Wikipedia Link Factor analysis is a statistical method used to describe variability

among observed, correlated variables in terms of a potentially lower number of unobserved variables

called factors. For example, it is possible that variations in six observed variables mainly reflect the

variations in two unobserved (underlying) variables. Factor analysis searches for such joint variations

in response to unobserved latent variables. The observed variables are modelled as linear combinations

of the potential factors, plus "error" terms. Factor analysis aims to find independent latent variables.

The theory behind factor analytic methods is that the information gained about the interdependencies

between observed variables can be used later to reduce the set of variables in a dataset.

21. Equity Swap, Wikipedia Link An equity swap is a financial derivative contract (a swap) where a set

of future cash flows are agreed to be exchanged between two counterparties at set dates in the future.

The two cash flows are usually referred to as "legs" of the swap; one of these "legs" is usually pegged

to a floating rate such as LIBOR. This leg is also commonly referred to as the "floating leg". The other

leg of the swap is based on the performance of either a share of stock or a stock market index. This

leg is commonly referred to as the "equity leg". Most equity swaps involve a floating leg vs. an equity

leg, although some exist with two equity legs. An equity swap involves a notional principal, a specified

duration and predetermined payment intervals. The term "tenor" may refer either to the duration or

the coupon frequency. Equity swaps are typically traded by Delta One trading desks.

22. Short Interest Ratio, Wikipedia Link The short interest ratio (also called days-to-cover ratio) represents

the number of days it takes short sellers on average to cover their positions, that is repurchase all of

the borrowed shares. It is calculated by dividing the number of shares sold short by the average daily

trading volume, generally over the last 30 trading days. The ratio is used by both fundamental and

technical traders to identify trends. The days-to-cover ratio can also be calculated for an entire exchange

to determine the sentiment of the market as a whole. If an exchange has a high days-to-cover ratio of

around five or greater, this can be taken as a bearish signal, and vice versa.

23. Sharpe Ratio, Wikipedia Link In finance, the Sharpe ratio (also known as the Sharpe index, the Sharpe

measure, and the reward-to-variability ratio) is a way to examine the performance of an investment by

adjusting for its risk. The ratio measures the excess return (or risk premium) per unit of deviation in

an investment asset or a trading strategy, typically referred to as risk, named after William F. Sharpe.

33
24. Marketable Collateral, Wikipedia Link Marketable collateral is the exchange of financial assets, such

as stocks and bonds, for a loan between a financial institution and borrower. To be deemed marketable

collateral, assets must be capable of being sold under normal market conditions with reasonable prompt-

ness at a fair market value. Conditions are based upon actual transactions on an auction or similarly

available daily bid, or ask price market.

25. Prime Broker, Wikipedia Link Prime brokerage is the generic name for a bundled package of services

offered by investment banks, wealth management firms, and securities dealers to hedge funds which

need the ability to borrow securities and cash in order to be able to invest on a netted basis and

achieve an absolute return. The prime broker provides a centralized securities clearing facility for the

hedge fund so the hedge fund’s collateral requirements are netted across all deals handled by the prime

broker. These two features are advantageous to their clients. The prime broker benefits by earning

fees ("spreads") on financing the client’s margined long and short cash and security positions, and by

charging, in some cases, fees for clearing and other services. It also earns money by rehypothecating

the margined portfolios of the hedge funds currently serviced and charging interest on those borrowing

securities and other investments. Re-hypothecation occurs when the creditor (a bank or broker-dealer)

re-uses the collateral posted by the debtor (a client such as a hedge fund) to back the broker’s own

trades and borrowing. This mechanism also enables leverage in the securities market.

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