020 - A Wealth of Experience - Trading Diversified Strategies in Futures & Equities with Perry Kaufman

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Getting into the Details of the Unique Approach of Perry Kaufman - Trading a Diversified Portfolio of Both Futures & Equities

In this episode of The Algorithmic Advantage, we had the pleasure of diving deep into the world of trading with the legendary Perry Kaufman. With a career spanning back to the 1970s, Perry's insights are invaluable, and his current trading strategies, honed over the last 15 years, continue to show remarkable success. While trend following remains his primary focus, Perry also incorporates divergence and timing strategies to enhance diversification. Our conversation, which lasted over an hour and a half, was a treasure trove of trading wisdom.

Trend Following, Market Noise & Diversification

Perry highlighted how increased market participation and technological advancements have influenced the efficacy of these strategies. He also provided insights into the shifting dynamics of the market, emphasizing the need for longer calculation periods and more sophisticated risk management practices as the markets mature and become more volatile.

Perry's view on trading many markets versus concentrating on only a few involves weighing the benefits of diversification against the potential for higher returns through focused trading. He states, "The idea is whether you should be diversifying into a large number of markets or trying to select which markets are most likely to contribute. Because if you can pick a small number of markets that have a high likelihood of good returns, you're going to get a much bigger payout than if you diversify into 50 markets." Perry emphasizes that while diversification reduces risk, it also tends to lower returns. Conversely, focusing on fewer markets can yield higher returns but comes with increased risk. He concludes, "So that's your big trade-off. You want to trade a smaller number of markets and look for a bigger payout, with bigger risk, or do you want the more conservative, highly diversified portfolio with less risk. And I think every trader has to make that choice. I'm a fan of smaller with more risk". Rich and I tend to think that there are ways of having your cake and eating it too – whereby there are ways to expand your universe while increasing profits. However, there are significant differences to the approach whether trading futures or equities, and this became a key part of the discussion. Futures offer market diversification and leverage that is very different to equities. Stocks, on the other hand, consist of an enormous universe, making a ‘relative’ selection (and ranking) more necessary.

Interestingly though, Perry essentially trades the same strategies on both futures and stocks. The absolutely critical part of Perry’s strategies, in both the futures and equities, is the nature of his ranking process. He effectively rotates candidates in and out of the portfolio based on their recent system performance. Importantly, ranked by their absolute returns only, and not any risk-adjusted method.

Strategy Creation, Portfolio Construction and Risk Management

Perry trades simple systems, uncomplicated by too many filters and indicators, and his models have evolved from shorter to longer-term trends over the years. The magic comes in the form of running a broad selection of these strategies to obtain an ‘average result’. One that is much more likely to be robust and perform as well out of sample as it does in a back-test. A man close to our own hearts!
He uses a combination of five different trend detectors and two confirmation indicators to decide whether to go long or short in both futures and stocks. With futures, where there are fewer to choose from, positions tend to be formed over multiple days, as different strategies ‘layer in’. With stocks on the other hand, with so many out there, only the best performers are selected and thus are ‘all in’ as the highest ranked stocks make their way into the portfolio. Using these methods, he avoids the need for stops and rather uses portfolio level ‘extreme volatility’ measures to exit the portfolio in times of unusual stress.

Perry also discussed his divergence and timing strategies, contrasting them with trend following. When trading shorter term systems, you generally want to take profits and run, otherwise you aren’t really diversifying away from your trend following models.

Impact of Technological Advancements

The impact of technology, including AI, on trading strategies was another key topic. Perry was a 'rocket scientist', coding since 1965, trading and writing books and articles ever since, so we wanted to get his view on this. While some fear that AI could make markets too efficient, Perry argued that markets will never be completely efficient as long as humans are involved. He explained that AI excels in closed systems but struggles with the constantly evolving nature of financial markets. Therefore, he does not see AI as a threat to traditional trading methods at this point. The discussion also highlighted how lower commissions and better tools have leveled the playing field for retail traders, allowing them to compete more effectively.

Conclusions

If you listen to this show a couple of times over, you could come away with some very powerful trading strategies. Sophisticated risk management and portfolio construction trump complex strategies and can create robust methods that stand the test of time. Trade using parameters that have been tested over a wide range and show robustness under all market conditions, then implement a mix of strategies designed to give you the average result. Pay careful consideration to whether you will be an ‘outlier hunter’ seeking to trap big moves in any market they may appear in, or whether you want to concentrate on a smaller group of markets that have shown consistency for your approach.

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