Here is the obligatory wrap-up of 2007 from my point of view, only a few days early.

Predictions for 2008

I have no specific, market-related predictions for 2008. I have found that I don’t use them in determining action anyways, and one of the benefits of being a small, active, retail trader is that I don’t have to play everything according to a theme handed down from management.

If the U.S. goes into a recession starting in the first quarter of 2008, I will owe a reader a post in his honor, for correctly “predicting” it. I’m not sure how much independent effort went into his prediction, and it took a little back-and-forth in the comments section to get a firm date commitment, but that’s really all I’ve got riding directly on “the economy.”

My inclination is to just trade systems that have shown themselves to be robust over all kinds of markets, so I’m not directly taking advantage of the contrarian opportunity I perceive in the continued negative sentiment on the U.S. “economy” and U.S. stock market. If I were, I would try to find a way to bet the “over.” There’s no scientific analysis or modeling involved in the vast majority of economic predictions, as the typical pundit just moves from cherry-picked out-of-context fact, to fear, to a sensationalist leap of illogic. This is the kind of crap you can expect when a chart of mortgage resets constitutes 90% of the typical content of a blog post on economics. Kind of funny and sad all at the same time, sort of like a mime, but there it is.

Overall, I expect that my posts on economics and economic models will be just as infrequent in 2008 as they were in 2007. To my knowledge, the only serious money to be made with economic models is by scaring folks into having you manage their money for them, and I’m not in either of those games at the moment.

Predictions Results from 2007

Last year’s predictions were along the lines of “it’s a bull market, buy something,” oil will be lower, the Fed Funds rate will be lower, and the market will have a somewhat better than average year. Some other stuff. Meh.

Returns

I’ll detail my personal returns in a separate post at the end of the year. Somebody else would be happy with them, I’m sure, but I’m sure not happy with them, as they’re well below my expectations and goals.

Options

In 2007, I wanted to investigate the idea of using options. I looked at strategies of buying options, selling options, and “complicated strategies” as in a combination of buying and/or selling options and/or stocks. My purpose was to see if any of these strategies would be an advantage over directional bets on stocks or ETFs through buying or shorting them, given my risk tolerance, activity level, and timeframe.

I ruled out selling options, because I don’t like the payout matrix of high winning percentage and low win amount to loss amount ratio. My personal preference in a trading system is for a winning percentage just high enough to keep me from getting discouraged, combined with as high a win amount to loss amount ratio as I can get.

Deep in-the-money (ITM) call purchases would have worked well in terms of strictly limiting my downside risk and sizing my positions, and would have made a decent stock replacement strategy for a trend-following system. I identified what I see as several items that made them less desirable than stocks are to me. First, only the initial stop is strictly limited, and I would either have to use a trailing stop on the option itself or rotate out the options to simulate a trailing stop on a stock. Second, many stocks I might pick have thin options markets. Third, there’s a time element to options that has to be accounted for. Fourth, there’s a potential for options mispricing (i.e. the option itself is either expensive or cheap relative to the underlying) that has to be accounted for. Finally, if I discarded the idea of using the call premium as a proxy for the amount of stop loss I would use on the stock, I’m getting into using leverage.

To varying degrees, using options to trade stocks results in trading the attributes of the options themselves and not trading the direction of the underlying. Getting away from the deep ITM calls means I’m more into the attributes of the options and less into the direction of the underlying.

It seems to me that the options game is much more hyperactive than I like to be. I’m holding out for a re-investigation if I ever move to trading full-time. I’m also holding out for an investigation of some index put-buying based on my Timing model’s interactions (if any) with whatever other systems I might be trading, but that’s way on-the-back-burner stuff.

Futures

Another area of investigation I wanted to examine in 2007 was the futures markets.

When applied to the stock market indices, the futures game is all about leverage. The implied overnight margin I looked at through my broker of choice was 15:1 or thereabouts at maximum, although for the systems I would use in my timeframe, I doubt I would want to avail myself of more than 2:1 to 4:1 leverage. I think I can get comparable returns on a compounded basis, with less volatility, by trading individual stocks or non-index ETFs directly. There may be advantages to futures over index ETFs in terms of liquidity, but I don’t have that much money to deploy and slippage doesn’t concern me at my chosen timeframe and level of leverage, and I think that by slicing and dicing into the components of the indices, I can make up for a 2:1 to 4:1 leverage in my timeframe.

From what I’ve seen, the advantage of the non-stock-index futures markets come from three places: (1) without the steady upward bias of stock prices, the futures tend to have both up and down trends, (2) it’s easy to find contracts with negative or very low correlation, and (3) leverage, again.

The money here is from assembling systems that trade baskets of these contracts simultaneously, either all long or long/short, in non-correlated sets. Then one applies enough leverage to bring the risk of ruin (or maximum drawdown) right up to the pain threshold, and voila!, there you go! From what work I’ve done, I need to have about 10x my current capital to get the kind of returns I’d like and still trade this type of system with a negligible risk of ruin.

So, I’ve tabled the futures idea for later.

Stock System Development

Here is probably the highlight of the year from my point of view.

After about a year to year-and-a-half semi-sabbatical, where I was trading different ideas and investigating different ideas, sometimes at the same time and sometimes in a “whack a mole” fashion, it’s time to settle down. That the returns in that time period are as good as they are, is part luck, and part that the variety of ideas tested weren’t all that bad. Some of them were downright good.

I’ve gotten the number of stock ideas, for which I’ve got good test results, down into the single-digits, with either complete tests or piecemeal by components. Of those nine or ten ideas, about a half-dozen of them fit my desired activity level and ongoing research time commitments, meaning that I can trade them “lazily” in part-time mode, based solely on end of day data. I’ve decided to track four of those ideas on a going-forward basis, and based on test results, I have two that are my favorites for personal use.

Way back at the start of this adventure, almost three years ago, my intention was to trade a “value” stock system based on rules, with discretion applied. Along the way, I did a lot of investigation into different types of systems, but after all this time, the basic idea hasn’t changed all that much – I’ve broadened out from “value” in the criteria, and narrowed down from “rules with discretion” to being almost purely mechanical. Other than that, the goal has been finding a system or group of systems that fits me, with anticipated results that come close to matching my goals.

In that sense, 2007 has been a very productive year.