Predicting direction is hard
Predicting direction is hard
It really is. So why bother?
What to expect - a less technical piece but a deeper intuitive understanding of how Sharpe Two approaches volatility trading.
What's a common trait among retail traders and conspiracy theorists? They're both drawn to the excitement of contrarian ideas—be it market makers and their algorithms, the Federal Reserve, or George Soros. In their quest to explain why the market doesn't behave as expected, they often find themselves embroiled in something much larger than mere investing. It becomes a battle of them against the world.
Imagine if profit and loss (PnL) were measured in dopamine release rather than dollars; we'd see many more 'successful' retail traders.
Unfortunately, PnL is all about the dollars. And the truth is, how you earn these dollars isn't the primary concern.
Ultimately, whether you amass wealth while yoloing on $GME or achieve financial independence through a steady, dollar-cost averaging approach, it's a win either way.
Regardless of the path you choose, the result is the same: your investments have elevated your standing in the game of life.
A focus on the Sharpe Two’s mission
However, it's essential to recognize that not all investment strategies are equally effective. Some paths naturally offer better chances of success.
Ever wonder why business schools never offered master's degrees in technical analysis? Have you ever seen any mention of your ability to “read the tape” on a Goldman Sachs job posting? Do you think Ken Griffin's trading secret sauce lies in “his levels” of where to buy and sell?
Your inner voice probably already knows the answer: Of course not.
If success in trading was as simple as drawing lines on a chart, hedge funds, banks, and other major financial institutions wouldn't pour billions into technology or compete fiercely for top talent.
The real key to success in trading must lie elsewhere.
If you've found yourself pondering these questions, then you're exactly where you need to be with Sharpe Two.
Sharpe Two is a volatility-focused research lab. We adapt strategies used by professionals for the retail trading sphere.
How do we achieve this? Since 2008, the technology landscape has transformed dramatically. Data has become more accessible, and programming languages like Python, R, and SQL are more popular than ever.
Let's be honest, though: competing with professional traders isn't our goal, nor is it realistic. However, we are committed to the diligent work required to leverage inefficiencies accessible to retail investors, adopting a more proactive approach to money management.
But to truly fulfill our mission, we must adhere to professional standards. We take great pride in the thoroughness and quality of our analyses, which we share publicly. Our performance assessment methods are crucial, too.
Boasting about performance on social media is one thing; consistently achieving a Sharpe ratio above one is another. Reaching and maintaining a ratio above two indicates a consistent ability to identify and manage profitable trades. This is the benchmark set by industry professionals.
This commitment to accountability is ingrained in Sharpe Two's ethos. You'll see us presenting ideas with high Sharpe ratios and success rates. We're also transparent about our processes, combining analytics with current market trends to reach our conclusions.
Let's take a step back for a moment.
What is the Sharpe Ratio again?
What exactly is the Sharpe ratio? It's a measure commonly used by professionals to gauge the risk level of a strategy quickly. The Sharpe ratio evaluates the return generated for each unit of risk taken. Let's illustrate this with a tangible example.
When examining these three strategies, a rational investor would typically opt for the one offering peace of mind, meaning the least volatile. In this case, it's Fund A, represented in blue, which avoids the extreme fluctuations in Funds B and C.
In its basic form, the Sharpe ratio is the return on a portfolio (Rp), adjusted for the risk-free rate (Rf, like a 1-year U.S. Treasury bill), and divided by the portfolio's volatility (σp). Ideally, you want the highest Sharpe ratio possible, indicating high returns with minimal volatility.
Sharpe Ratio = (Rp - Rf) / σp
At Sharpe Two, our goal is to present trading ideas with a Sharpe ratio of, well, you’ve guessed it, at least two or very close to it
How do we achieve this?
Our investment philosophy isn't about being categorically right or wrong. We avoid making audacious predictions about market directions. After all, accurately predicting market movements is challenging.
Remember, there are no extra points for making investing harder than it needs to be. While your ego might care about such feats, the market certainly doesn't.
Revert to the mean is the path-forward
Predicting market direction is difficult because it follows what's known as a 'random walk.’ This mathematical term implies that the likelihood of the market moving up or down is roughly equal (about 50/50) at any given moment and in any timeframe.
Volatility is a unique beast—it doesn't follow a random walk. In fact, it's the only asset class known to exhibit true mean reversion.
What does this mean in simple terms?
Most of the time, it goes down. When it goes up, it tends to go up big time, but only sometimes.
Easy enough? Let’s take a look.
This is the VIX index, the most renowned measure of implied volatility in the S&P 500, observed over the last five years.
Why are we fans of the VIX? It spares us the need to grapple with complex candlestick charts or draw lines that would make Kaminsky envious.
Most of the time, the VIX trends downwards. But when it rises, it often surges significantly, albeit infrequently.
And the best part? No need for convoluted mathematical equations that intimidate many or for intricate macroeconomic theories.
The basic intuition is straightforward: if the VIX is high, expect it to decrease. And if it's low? It can remain low for a prolonged period, making predicting when it will rise again is more challenging.
Remember, we aim to simplify our trading life. There's no extra credit for accurately predicting the next major market event. Whether you're long or short on volatility, the risks are distinct, but the potential consequences are similar—if you're not cautious, you could decimate your account.
Though less complex than predicting stock trajectories, trading volatility still harbors its own risks and requires a solid methodology. Shorting it because it's high or buying it because it's low are not sound strategies.
Why is this the case? Implied volatility possesses a crucial, yet often misunderstood, property. It represents a collective forecast of potential market movements within a specific timeframe. Essentially, it gauges the market's expectation of future volatility.
It might seem appealing to take a contrarian stance against this collective view, but it's seldom profitable.
If the market consensus is that little will happen in the upcoming weeks, even if your instincts suggest otherwise, the market's prediction usually prevails.
Conversely, if the market braces for short-term volatility, wishing for a sudden calm against the prevailing tumultuous trends is often futile.
Your contrarian perspective might have hit the mark occasionally, but the collective judgment tends to come out on top in the long game.
Trading volatility might not seem any simpler at this point.
But don't lose heart—the exciting part is just beginning.
All you need is nuance.
While the collective market view is often correct, it's not always precise. In fact, a consensus of opinions tends to lean towards more extreme predictions than what reality warrants.
Consider elections: how often has the collective correctly predicted the winner, only to be surprised by the unexpectedly narrow margin of victory? Trading follows a similar pattern.
When the market anticipates volatility, outright dismissing any volatility is unwise. A more astute approach is to discern whether the market is overestimating the level of volatility.
This is where our expertise at Sharpe Two comes into play. We start with a detailed analysis of the prevailing market narrative—be it Federal Reserve policies, a surge in the semiconductor sector, or fluctuations in oil markets. Then, we delve deep into the data to evaluate if the market's response is excessively reactionary. The subtlety here is key. We're not suggesting the market won't experience volatility; rather, we propose it's not as volatile as currently priced.
And there you have it: our 'secret sauce' at Sharpe Two (and, incidentally, a common strategy among many professional institutions). Of course, that's not the whole story—we wouldn't want to overwhelm you with the intricate calculations we perform behind the scenes.
As you grasp these nuances of market volatility and our approach at Sharpe Two, you're well-prepared to delve into our analyses. Particularly, our 'Signal du Jour' will be of immense interest, where we meticulously outline the trades and positions we take in the market. This feature reflects our deep understanding of the market dynamics and offers you actionable insights that could be instrumental in your trading journey.
We encourage you to join us in this exciting venture. By staying informed and applying these insights, you're not just a passive observer but an active participant making informed decisions in the ever-evolving world of finance. We look forward to having you on board and navigating these market waters together.
Be sure to follow us on Twitter @Sharpe__Two for more of our insights. If our work resonates with you, don't hesitate to share it with others who might find it helpful.