“I believe in self-fulfilling prophecy”
Algorithmic trading is often surrounded by the nimbus of mysterious and impenetrable. But with the right tools and methods, the opportunities and risks of automated trading strategies can be exploited. Philipp Kahler, Senior Quantitative Analyst at Intalus Group, showed the way to systematic investment at the 120th Hedgework in Frankfurt.
Hedgework: Mr. Kahler, in short: What is Algorithmic Trading?
Philipp Kahler: Algorithmic Trading is trading with pre-defined and tested rules. The rules can come from higher mathematics, where game theory has its roots or is based on technical analysis.
Hedgework: Why should institutional investors focus on technical analysis and algorithmic trading?
Kahler: The technical analysis displays information quickly and clearly. Contrary to this are the many investment recommendations in the subjunctive; that the stock XY next week should be bullish for the reasons and could reach a new high. Then a purchase might be advisable. The rule-based technical analysis does not dare to speculate. The software simply pings when a situation arises that is in line with the rules. In real time, and not maybe and next week.
Hedgework: How does it work?
Kahler: I like to program rule-based strategies with indicators and chart patterns. One or two classical indicators define the market phase, a chart pattern or an oscillator signal then gives the final GO for entry. The position is then hedged by a sales and time stop. If nothing happens or if it goes wrong, the position is closed. Any accumulated profits and any counter-signals then lead to new exit instructions for the following day at the end of the day.
So I’m not trying to predict what might happen tomorrow, but my algorithm contains a number of rules for scenarios that stand for and against my position. Just as an emotionless and deliberate professional would do.
Hedgework: What indicators do you look for?
Kahler: I like to use classics such as moving averages, Directional Movement Index, Parabolic or ADX for trend determination. For entry or exit, significant high and low points, candlestick formations, oscillators. Generally speaking, I use indicators that other traders use, but I don’t always use them in the classic way. And I believe in self-fulfilling prophecy (laughs).
Hedgework: Why do you use technical analysis to develop algorithms?
Kahler: Technical analysis shows me how the others see the market. One can now argue whether the markets are efficient and whether every available information is reflected in the price, but this is a theoretical discussion. In practice, I see that other traders use technical analysis to determine entry and exit. And I don’t want to ignore that information.
Hedgework: You are thus betting very heavily on the right time to buy and sell. The latest research is more in the direction that market timing is not possible or does not bring anything.
Kahler: Let’s assume this hypothesis is correct. Timing is not possible. Then the movements of the markets are a purely random walk. Yesterday’s events have no influence on today’s events. And this is clearly contradicted by every insight into one’s own experience and behavioral finance. Yesterday influences how we think and act today. And that gives me the foundation of technical analysis.
If the market then falls by 20 percent in one day and they don’t stop because timing doesn’t work, they can do so tomorrow at -30 percent. Or write an article about why this was the right thing to do at that time, as the market is now back to baseline again.
Hedgework: How can the market universe be searched for promising values using algorithms?
Kahler: Define promising! Values that have been in trend for a long time and for which you hope that they will rise for a few more days? Or values that are at least 75 percent below their high and now trade at twice as much volume as a year ago? Values where a reversal pattern has occurred today that every retailer knows?
The beauty of scanning the markets is that you can find out from thousands of values exactly those that meet your own rules.
Hedgework: You compare the values at different time levels. What is the reason for or statement can the user draw from the comparison?
Kahler: I think that mass psychology works best where there are masses. So, if only the people who see a candlestick pattern on the 60-minute chart come into this market, then the following movement will probably not be so great. However, if the same candlestick pattern appears on the weekly, daily and 60-minute charts, there is likely to be more movement as more traders are involved. Since this is not easy to find, I have to rely on automated scans of my software. Manually looking for these scenarios would degenerate into work.
Hedgework: Be long when the chart is green and short when it is red. That sounds trivial. Is that really it?
Kahler: When the pedestrian lights switch to green, do you walk blindly across the street? Or maybe you want to check again if there is no car coming?
Same with one of my red-green models. The colour is comparable to the traffic light. The second step is to confirm the trend with a new high or low. Then there is also the question of positionsizing and risk management. All these are simple building blocks that combine to form a rather complex trading model.
Hedgework: Is this approach also suitable for institutional investors who do not have a large investment team?
Kahler: Technical Analysis is a useful tool for this type of analysis. It allows me to automate a lot of things, such as scanning markets and baking strategies. Automatically generated trading signals and alarms are then the mechanical assistants that enable the Portfolio Manager to monitor a universe of markets and strategies in a short period of time. Fortunately, the software industry has reached the point where there is hardly any need for dedicated programmers, but at least the first prototype can be created by the dealer himself.
Hedgework: In volatile markets in particular, this sounds like a lot of reallocations and transactions and transaction costs. This is at the expense of performance. What is your experience?
Kahler: But in volatile markets, however, there are also the best opportunities. If the markets move, money can be earned well.
However, the cost of reallocations and the associated work involved are clearly an important criterion in system development. The number of transactions can be adjusted by selecting the time levels and trading approaches in such a way that it can be done with the given trading team.
Hedgework: How long is the average holding period?
Kahler: If it goes wrong, it only takes a few seconds. In my strategies, however, I usually work several days to weeks.
Hedgework: Does the approach also work at portfolio level?
Kahler: It works particularly well at portfolio level thanks to diversification. It is almost impossible to achieve a steady performance with only one traded value. However, if I am dealing with a universe of non-correlated values, then continuous performance is possible with relatively simple strategies.
Hedgework: How do you determine the optimal position size in a portfolio?
Kahler: I risk the same amount per trade, depending on the planned trading frequency and within certain limits for the invested capital. The various systems are also weighted according to the volatility of the results.
Hedgework: What happens to the money that does not flow into the stock market due to negative signals?
Kahler: No absolute return approach will always be invested. That is why it makes sense – irrespective of the investment issue – to be active in several markets and time levels. Cleverly chosen, with little correlation to each other, the investment ratio then remains fairly constant and the problem is eliminated.
Hedgework: What is the equity/bond ratio in a portfolio? Does the stock market always have priority?
Kahler: No, no, not just stocks or pensions. Absolute return means that at the end of the year you want to see a certain return at a given risk. It is not known which market this will bring me in the future. Surely the Bund Future has been good at trend-following strategies in recent years, but what about next year? Perhaps the return on investment then comes from oil, gold or other sources. That is why the idea is to search markets for certain rules and then act where the traffic lights turn green.
Hedgework: In which market environment does this approach work best and where not?
Kahler: I like working with trend-following strategies. They are easy to develop and implement on the market. In order to ensure that the yield is right, the trends should not be too small, both in terms of time and volatility. And this is where the scanning method comes into play again. I have to look for the markets and time levels in which the markets meet my criteria. Or I need to have a switch for another strategy, one that works well in sideways markets.
Hedgework: How do you deal with black swans and chance?
Kahler: There’s not much you can do about a real Black Swan within the trading system world. After all, by definition, it is a risk that has not been known to date or has been completely misinterpreted. Only a strategy outside the stock market can help.
But all the market shocks that have occurred in history must be looked at very carefully. Not only on the chart, but best in conversation with participants. It doesn’t look so wild on the chart, but when you see how everything else goes wrong on such days, you don’t automatically invest everything in a market-system combination.
Hedgework: What is the advantage of your strategy over other trading strategies based on technical analysis?
Kahler: It’s my strategy. I developed it according to my convictions and it does what I would do by hand. This doesn’t have to be any better than all the other strategies on the market, but the trader’s psychology also comes into play in system trading. If you don’t believe in your strategy, you leave it at the first setback and then you’re not in the good phase. A good system only makes losses – simply because it is used in the wrong environment or by the wrong dealer. My advice: always be honest with yourself. The rule-based technical analysis supports this, as it leaves no room for interpretation.
The interview was conducted by Alexander Heintze, translated by Deepl Übersetzer