Friday, March 16, 2018

The Importance of Idea Velocity in Trading

One's skill as a trader is only as good as one's ability to generate ideas worth trading.  This is an underappreciated aspect of trading performance.

Specifically, we can look at the idea velocity of a trader--the number of independent ideas generated per unit of time--as an important component of trading success.

Why is this?

Imagine a trader who generated one good trading idea per year.  That one trade would have to be sized quite meaningfully and held for quite a while to generate a year's worth of income.  Indeed, it really wouldn't be a trade; it would be an investment.  But with only one idea per year, it would be an undiversified investment.  If the idea didn't work out, losses could be significant, but more importantly there would be no other source of returns.  Over time, such a low velocity trader/investor would have a very lumpy set of returns, unless they just happened to hit one big idea after another infallibly.

At the other end of the spectrum, imagine the skilled daytrader who notices many different trades setting up among many different stocks or instruments.  That trader is highly diversified on a serial basis, as each day's returns reflects the probabilistic outcome of many bets.  That will produce a smoother equity curve.

The skilled hedge fund manager generates many independent trade ideas at one time and weights them properly within a portfolio to achieve diversification benefit.  The idea velocity is achieved by researching across multiple markets and strategies and putting on many bets at once.

In my recent webinar (you can listen to it here), I emphasized that there are two broad sets of skills that define successful trading:  pattern recognition and analysis.  I also pointed out that extraordinary returns in trading come from unusual talents and skills in at least one of these areas.  An important way that these skills are manifest is through idea velocity.  When someone is a great pattern recognizer, they recognize many patterns.  When someone has great analytical skill, they research effectively and generate many ideas.  Profound talent and skill manifest themselves in creativity.

A recognition of the importance of idea velocity helps us appreciate why, increasingly, we're seeing superior returns among discretionary portfolio managers who make use of quantitative models and trading strategies.  Computers simply have more bandwidth than people, both in terms of the number of patterns that can be recognized and the number of markets and strategies that can be researched.  Moreover, the use of automation enables the trader to not only generate many ideas but trade them simultaneously--again vastly expanding the number of sound, independent bets placed per unit of time.

A recognition of the importance of idea velocity also helps us appreciate why traders learn and perform better in team settings.  Teams model more and different ideas and ways of generating ideas and teams share ideas they generate.  A team of discretionary traders, each of who generates independent models and automates their trading strategies, is powerfully diversified, able to make money in dozens of ways.  

Idea velocity encourages us to get broader, not just bigger.

Further Reading: