Evaluating collective2 strategies

There are countless Collective2 strategies to choose from (more than five hundred, as I’m writing this !). It may be a bit overwhelming at first, even frightening when the main tool at your disposal looks like this :

Collective2 strategies displayed by "the grid"

This article aims at helping you evaluate these strategies, and choose the right ones for your portfolio.

Collective2 strategies categorization

Systematic or discretionary ?

The strategy can be either systematic (meaning a computerized strategy) or discretionary (decisions are made by an human). It’s of course possible to mix these two aspects, by having the developer validate the computer’s decisions !

One appreciable thing about systematic strategies is that they’re disciplined. If the programmer includes a stop loss, the program won’t shift it by itself in order to “see what will happen”. It won’t revenge trade, or enter trades due to boredom. Basically, it removes all human flaws which makes that most traders fail.

Of course, computer programs also have drawbacks : the most obvious is that they can have bugs. A basic strategy using simple technical indicators will probably be foolproof in that regard, but even in this case, it may fail due to a bad data feed !

Timeframe and trading frequency

Another aspect to consider is how often the strategy enter trades, and how long the positions are kept (obviously these two considerations are linked). An intraday strategy will lead to higher broker commissions , and will probably require you to use auto-trading to be effective.

Asset class traded by Collective2 strategies

Basically you have the choice between stocks, ETFs, options, futures and forex. Although it’s not an asset class strictly speaking, I also tend to think of volatility as a separate category.

Let’s look at the pros and cons of each of them. For each asset class, I’ll consider the following aspects :

  • leaning curve : how easy it is to understand the mechanics of these instruments
  • scalability : how easy it it to scale down the strategy using these instruments
  • availability : how likely is it that you’ll trade them using your broker

Stocks

Stocks are straightforward to understand. However, one aspect of stocks trading may take some time to get used to : it’s short-selling. Collective2 strategies may bet that a stock will go down. They sell the stock first, before buying it back (cover it). If the price actually went down and they cover lower, it results in a profit; otherwise, it leads to a loss. Note that not all brokers allow short-selling, or may restrict it for some stocks (hard-to-borrow stocks). Moreover, as you actually need to lend to stock from another trader, you have to pay interests for this.

Scalability is not a concern when trading stocks, as their price is usually low. Neither is their availability : most brokers will let you trade these, unless they specialize in another asset class !

ETFs (exchange-traded-funds)

ETFs are recent instruments which usually replicate the variations of an index, sometimes increasing it by a leverage. The most famous is the SPY, replicating the performance of the S&P 500 index; another more contrived example is LABD, which replicates 3 times the inverse performance of the S&P Biotechnology Select Industry Index. If this index gains 1%, the LABD will lose approximatively 3%; conversely, a 1% loss for the index will translate to a 3% gain for the ETF.

From the point of view of an investor using Collective2, ETFs are not much different from stocks. Brokers used to trade stocks will also allow ETF trading, and they scale in just as easily.

Note that volatility ETFs are a special case, studied below.

Futures

Futures are traded on margin, meaning you only have to deposit a certain sum (usually between $2000 and $4000), which will be used to cover you eventual loss. Thanks to this mechanism they have a nice leverage. However one drawback is that it’s though to scale in. Moreover, the overnight margin is larger than intraday margin, so you have to know your strategies and plan your size carefully if you don’t want to be liquidated at the end of day !

Unlike stocks, they’re very sensitive to the time and are thus harder to grasp.

Forex (currencies)

Trading forex provides a nice leverage. Compared to stocks, they may be more volatile, and of course more sensitive to external events or news. There’s not much concern about scaling in, although the lot size (amount of currency traded) is fixed.

Options

Options are probably the hardest instrument to understand. They can be extremely volatile (intraday swings of more than 100% are not rare !), leading to the opportunity of large gains… or losses of similar proportions ! Scaling in is easy.

One drawback not much encountered with other asset classes is the large slippage : options can be a fast-moving market, and the price you’ll receive for your trades may sometimes be much worse than other traders !

Consider the following auto-trade data :

There’s a 6 cents difference between the best execution and the worst one. While it may not look like a lot of money, it translates to a $10 PNL difference by option. I was lucky to be the one filled at the best price. But in the worst case ($1.47 fill), with my quantity of 20 options, my profit would have been reduced by $120 !

Volatility

In this asset class I’ll include ETFs like SVXY, UVXY, VIX, VXX… and options on these instruments. These ETFs trade like stock but their price action is much different, and leveraged ones may have large swings.

Note that in order to control the risk, Collective2 strategies may use options in addition to volatility ETFs, making them harder to scale in.

Risk management of Collective2 strategies

For me this is the alpha and omega of trading. I tend to focus on strategies that control their risk closely. What’s the point of doubling your account if you risk loosing all your gains ?

Here’s the kind of equity curve I don’t want for my account (I redacted the strategy name) :

Yes, you read it correctly : eighty percent loss in July ! That’s crazy.

So, the first thing I do is inspect the equity curve. Large drawdowns are suspect; I prefer to see the equity curve moving smoothly. In the screenshot above, the May drawdown was much larger than the previous ones ! (Disclaimer : this didn’t prevent me from stupidly subscribing to this strategy at the worst possible time)

The drawdown percent displayed by C2 may trigger another red flag for me.

Examining the transactions list is the next step : check the “drawdown %”‘ column, and see if the values are acceptable to you.

Finally, if the result of these checks is satisfying, I usually take advantage of the free trial period when it’s available. If the strategy sets well-defined stop-loss and profit-taking orders, then I’m basically sold !

Risk management, continued : short-selling calls on volatility products

If the title of this paragraph looks like gibberish to you, I’ll try to explain it without too much jargon ! It means that the strategy bets that volatility will decrease (which it usually does). When the volatility drops, the price of the call options associated with it also decreases; the strategy thus sells these options short (it bets their price will go down). Trouble is, the price of these options is also likely to skyrocket in case of a huge volatility spike !

I started trading such a strategy when I was new to Collective2. I quickly received a notification from my broker, stating that I could lose up to 4 times the size of my account (!), and charging me a daily fee as a result. While this figure is probably unrealistic, large volatility spikes do regularly happen. Case in point is yesterday (August, 10th 2017), when the VIX index measuring volatility gained a whooping 39%. The equity curve of a popular volatility strategy dropped from $34k to less than $25k ! Even with stops in place, slippage will lead to bad fills and large losses.

I personally don’t trade Collective2 strategies that employ such a tactic anymore. If I had to pickup a volatility strategy, I’d go for one using ETFs (mostly using XIV/VXX or UVXY for more leverage), and using options as an hedge against such adverse moves. Of course, it totally depends on your risk tolerance !

If you’re under PDT rule

PDT rule (pattern day trader) aims at preventing you from day-trading in case your account is below $25000.

In this case, you may trade forex or futures, which are exempt of PDT rule. Another option would be to follow strategies that swing trade (although even these can fall under PDT rule if stopped out too often !).

 

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