requires real-time market data over a large universe of stocks. (You can, of course, subscribe to a third-party market data vendor, but then the extra cost may not be justifiable if your trading capital is low.) Similarly, clean historical stock data with high frequency costs more than historical daily stock data, so a high-frequency stock-trading strategy may not be feasible with small capital expenditure. For historical stock data, there is another quality that may be even more important than their frequencies: whether the data are free of survivorship bias. I will define survivorship bias in the following section. Here, we just need to know that historical stock data without survivorship bias are much more expensive than those that have such a bias. Yet if your data have survivorship bias, the backtest result can be unreliable.
The same consideration applies to news—whether you can afford a high-coverage, real-time news source such as Bloomberg determines whether a news-driven strategy is a viable one. Same for fundamental (i.e., companies' financial) data—whether you can afford a good historical database with fundamental data on companies determines whether you can build a strategy that relies on such data.
Table 2.2 lists how capital (whether for trading or expenditure) constraint can influence your many choices.
This table is, of course, not a set of hard-and-fast rules, just some issues to consider. For example, if you have low capital but opened an account at a proprietary trading firm, then you will be free of many of the considerations above (though not expenditure on infrastructure). I started my life as an independent quantitative trader with $100,000 at a retail brokerage account (I chose Interactive Brokers), and I traded only directional, intraday stock strategies at first. But when I developed a strategy that sometimes requires much more leverage in order to be profitable, I signed up as a member of a proprietary trading firm as well. (Yes, you can have both, or more, accounts simultaneously. In fact, there are good reasons to do so if only for the sake of comparing their execution speeds and access to liquidity. See “Choosing a Brokerage or Proprietary Trading Firm” in Chapter 4.)
Despite my frequent admonitions here and elsewhere to beware of historical data with survivorship bias, when I first started I downloaded only the split-and-dividend-adjusted Yahoo! Finance data using a now defunct program. But now you have easy and free access to that via many third-party APIs (more on the different databases and tools in Chapter 3). This database is not survivorship bias–free—but I was still using it for most of my backtesting for more than two years! In fact, a trader I know, who traded a million-dollar account, typically used such biased data for his backtesting, and yet his strategies were still profitable. How could this be possible? Probably because these were intraday strategies. So, you see, as long as you are aware of the limitations of your tools and data, you can cut many corners and still succeed. (There are now affordable survivorship-bias-free stock databases such as Sharadar, so I recommend you pay a small fee to use them.)
TABLE 2.2 How Capital Availability Affects Your Many Choices
| Low Capital | High Capital |
|---|---|
| Proprietary trading firm's membership | Retail brokerage account |
| Futures, currencies, options | Everything, including stocks |
| Intraday | Both intra- and interday (overnight) |
| Directional | Directional or market neutral |
| Small stock universe for intraday trading | Large stock universe for intraday trading |
| Daily historical data with survivorship bias | High-frequency historical data, survivorship bias–free |
| Low-coverage or delayed news source | High-coverage, real-time news source |
| No historical news database | Survivorship bias–free historical news database |
| No historical fundamental data on stocks | Survivorship bias–free historical fundamental data on stocks |
Though futures afford you high leverage, some futures contracts have such a large size that it would still be impossible for a small account to trade. For instance, though the E-mini S&P 500 future (ES) on the Chicago Mercantile Exchange has a margin requirement of only $12,000, it has a market value of about $167,500, and a 10 percent or larger daily move will wipe out your account that holds only the minimum margin cash. In case you think that a 10 percent or larger move for the S&P 500 index is extremely rare, check out how many times it happened from February to April 2020. Instead, you can trade the micro E-mini contracts (MES), which has only one-tenth of the margin requirement and market value of the regular E-mini.
Your Goal
Most people who choose to become traders want to earn a steady (hopefully increasing) monthly, or at least quarterly, income. But you may be independently wealthy, and long-term capital gain is all that matters to you. The strategies to pursue for short-term income versus long-term capital gain are distinguished mainly by their holding periods. Obviously, if you hold a stock for an average of one year, you won't be generating much monthly income (unless you started trading a while ago and have launched a new subportfolio every month, which you proceed to hold for a year—that is, you stagger your portfolios.) More subtly, even if your strategy holds a stock only for a month on average, your month-to-month profit fluctuation is likely to be fairly large (unless you hold hundreds of different stocks in your portfolio, which can be a result of staggering your portfolios), and therefore you cannot count on generating income on a monthly basis. This relationship between holding period (or, conversely, the trading frequency) and consistency of returns (that is, the Sharpe ratio or, conversely, the drawdown) will be discussed further in the following section. The upshot here is that the more regularly you want to realize profits and generate income, the shorter your holding period should be.
There is a misconception aired by some investment advisers, though, that if your goal is to achieve maximum long-term capital growth, then the best strategy is a buy-and-hold one. This notion has been shown to be mathematically false. In reality, maximum long-term growth is achieved by finding a strategy with the maximum Sharpe ratio (defined in the next section), provided that you have access to sufficiently high leverage. Therefore, comparing a short-term strategy with a very short holding period, small annual return, but very high Sharpe ratio, to a long-term strategy with a long holding period, high annual return, but lower Sharpe ratio, it is still preferable to choose the short-term strategy even if your goal is long-term growth, barring tax considerations and the limitation on your margin borrowing (more on this surprising fact later in Chapter 6 on money and risk management).
A TASTE FOR PLAUSIBLE STRATEGIES AND THEIR PITFALLS
Now, let's suppose that you have read about several potential strategies that fit your personal requirements. Presumably, someone else has done backtests on these strategies and reported that they have great historical returns. Before proceeding to devote your time to performing a comprehensive backtest on this strategy (not to mention devoting your capital to actually trading this strategy), there are a number of quick checks you can do to make sure you won't be wasting your time or money.
How
