Compounding is Frequency-Driven

i said i’d post a chart here to illustrate my theory that the trader seeking to maximize the number of trades will outperform the trader seeking to maximize gain. the chart below shows how this works. depending on whether you’re in midcaps or microcaps, market reality varies. i don’t have stats for this but, in general, the longer you hold either one the more likely it is that you’ll have to exit with less than your target (assuming a weekly time constraint, which is how this Experiment is set up).

<> so the trader who seeks, say, a 40% gain is very likely to experience a high number of fakeouts, and will accordingly exit at far less (i’ve arbitrarily assigned 15%). but the same trader, with the same skill, can much more often grab a quick 10% gain. in “my opinion”, the high-gain trader also faces increased likelihood of hitting their stop-loss before they hit their 40% gain- which presents a decision crisis (do they exit with loss or hang on wasting time waiting for recovery?). conversely, the 10%-gain/maximizing number of trades player is much more likely to achieve her/his goal. much of this comment is based only on my observation and experience, not actual data. but i’ve tried to be fair in designing the chart below to accomodate realistic possibilities. i should note that if we instead allow the high-gain trader to achieve 20% or more, they do begin to outperform the 10% trader. all comments are welcome.

Approaches: Challenges and Remedies

Orangequant Comments:
it might not be obvious to you when you first visit this blog just how complex an undertaking this is. when we start posting our activity next week all you’ll often see is the trades and gains/losses. but there are underlying issues as well- things which make this 10% compounding goal very challenging…

Scmfinance and i (orangequant) will vary in our techniques for handling these challenges, i’m sure. scm has already mentioned these issues (“…settlement periods, commissions, and trading on multiple boards…”) and i’d just like to elaborate a bit and share my own plans for coping with these challenges. (Scm recently mentioned to me the idea of “two-tracking” our initial bankrolls and i hope scm will fill us in on that some more, as i think it’s very important.)

the 3-day settlement rule actually has three edges. first, it requires the trader to wait three days after closing a trade for settlement and availability of funds; second, if the underlying security has already been held for at least three days, then the close produces “instant cash” (except as in the following third edge case); third, if the trade is closed at any time before the lapse of three days from its open, then the 3-day rule engages afresh (starts the three-day count over). instead of “sell”, i use the phrase “closing a trade” here so as to include both long and short trading.

<>this third edge of the 3-day rule can deal a crippling blow to any plans for minimum once-a-week roundtrip trading. Ideally, to maximize the periodic number of trades under the 3-day rule, one would want to exit the trade either on Day Zero (i.e., same day roundtrip), or on Day Three.

The Tortoise and The Hare

of course, the Elephant In the Room here is gain maximization per trade vs long-term gain maximization. in other words, will you do better to focus on maximizing your gain in each trade and ignore the 3-day rule, or will you do better to focus on maximizing the number of trades over the year? instinct and “common sense” tell us to maximize gains on each trade. that’s how most traders behave and, in my opinion, it’s dead wrong. instinct and common sense are just no match for spreadsheet wisdom. across one year, assuming equal skills, the trader focused on maximizing the number of trades will do very substantially better than the one focused on maximizing per-trade gain.

i’ll provide some charts here later to illustrate my point, but for now i’ll just make the point that compounded gain is strongly frequency-dependent. since about half the time my approach is through quantitative analysis (“quant”), i try to notice these little things. in all of this it’s also important to realize that the 3-day rule, used efficiently, actually permits the closing of up to 1.66 trades per week (after the first week).

<> Reader comments are welcome. Scm, what do you think?

the hypothesis

Using a variety of trading techniques and starting with only $500 for orangequant and $1000 for myself, we will each attempt to show that it is possible to return at least $50,000 (or 10,000%) in a period of 52 weeks. Our goal is to earn as little as 10%/week, which will usually amount to one play/week. Aside from making the right plays, we will have to deal with a variety of other factors including: settlement periods, commissions, and trading on multiple boards (Pink Sheets, OTCBB, Nasdaq, etc.) We will update our readers as much as possible regarding our plays, but will not give updates until we have exited a play entirely, so as not to influence the experiment in any way. Lastly, this is not a competition between the two of us — we are both pulling for one another and will on occasion seek advice from one another. The whole point of this experiment is to show other investors that you don’t need large returns on large investments, but rather that money can be made with small returns on small investments — as one of our good friends always says, “There’s no such thing as a bad profit.”