This is the last of the series of posts on the first incarnation of CASTrader. In Part I, Part II and Part III, I looked at the good, the bad, and the ugly points of CASTrader I, respectively. In this post, I promised I would look at how to improve CASTrader. It's good to have a critical eye for anything like this, but I think I was worrying about some things more than I needed to, at least for the moment.
The Ugly. First, I'll tackle the ugly - the 75% drawdown in capital suffered during the simulated 16 years between the heat of Vietnam through the days of disco, and the early Reagan years. Basically, I'm not going to sweat about this - yet. Even if a similar period repeats starting the day I take CASTrader live, a period like this would just be a slow bleed of capital. This means I've got time to solve this problem in a meaningful way. I've concluded CASTrader needs more information than price alone to perform well during a period like this. Although I plan to add every scrap of tradeable information anyone ever thought of eventually, I think the key piece of information needed most right now is interest rates, so they will be added to CASTrader II. It's important for traders (or any investor) to evaluate the tradeoff between "risk-free" return and speculation on securities. CASTrader is no different. I don't know if this will solve the problem, but I've got time to find something else if it doesn't.
The leverage problem. This is the problem where CASTrader wants to use up to 7x leverage because the Kelly Formula is telling it to. Actually, I throttled the run at 7% maximum leverage, because it wanted even more leverage to post even more absurdly astonishing (and unrealistic) results. I'll carefully let CASTrader build up to whatever leverage it (and I) can handle (within reason), and use put/call options (probably deep in-the-money) to give it that leverage and limit my risk of a Black Swan event. I can put a hard floor on my downside (to what I paid for the calls or puts) with no cap on upside that way. If CASTrader can perform anything near what it does in the simulation, the added friction of options (vs. futures) won't matter.
Transaction costs. Transaction costs are mainly a slow-bleed type problem before 1983 in the simulation, so like the "ugly" problem, I have time to solve this. That said, CASTrader II will to factor in real transaction costs, which will result in less trades and less profits, particularly in a pre-1983 style market. Again, if CASTrader can perform anywhere near like it did post-1983 for the near term, improving performance after transaction costs is a back-burner problem. That said, I have an ace up my sleeve - a dark market. CASTrader II will have one, and it will be better than the rudimentary one in CASTrader I, and if I'm correct, it will minimize transaction costs. There will still be transaction costs that limit CASTrader's ability to trade, but they will be less and less of a factor the more diverse algorithms I add to CASTrader (more partial diversity).
The paper to real world problem. The easiest way to solve this is to start small and ramp up. The first time CASTrader goes live, it will be with maybe 5% of my investable capital. As I begin to trust it's performance, and assuming it's good, I'll add to that. If I don't, it's back to the drawing board for CASTrader III. CASTrader II will slowly get a feel for the real world. It will have the opportunity to learn and adapt to whatever is different between paper and real world without the opportunity to lose what I don't want to lose. A few other ideas I'll implement are:
- Add whatever sources of real intraday data to the simulation I can so it is as realistic as possible.
- Increase the trader base from 1000 to perhaps 1,000,000+. Each of the current runs of CASTrader takes about 2 hours for the 90 years of data. This means 83 days of my computer running 24/7 to do the 1000 extra simulations. It's time to drag out the old junk computer(s) and put them to work, and probably buy a faster one. It's a good thing it will be winter and the heat will at least go to good use. Since the traders will likely have wealth distributed according to some power law, each additional batch of traders will increase the chances of finding even better traders than the elites of the simulations described previously. At a minimum, I'll have a somewhat more diverse set, because each run produces a slightly different result. At the risk of datasnooping, I'll kill off any traders that haven't made some minimum return after the 90 years, simply to allow CASTrader to go live with a manageable number. At a minimum, if they can't pay for their meager computation expense along the way, they'll die (cruel and Darwinian, but effective - I promise they won't even feel it). By the time I go live with 100% bankroll, I may have simulated some 20,000,000+ traders (4.5 years of laptop computation time! I'll definately need more computers, assuming the little buggers can pay for them).
- For every trader that makes the cut, I'll apply a pretty extreme discount factor such as the square root or even the log of their bankroll as a "weight" for how much capital they receive when they go live. This will "punish" the elites and "reward" the also-rans. This is counterintuitive, but it will add a little magic of partial diversity back in. It is simply a risk/reward tradeoff that trades the risk an elite will do very poorly going live vs. the opportunity cost that it does just as well or better. Elites who can do well in the real world will quickly emerge and dominate again. This also gives CASTrader a chance to get used to the cruel, cruel real world before losing a lot of money in it.
Ther are still no plans for genetic reproduction of traders, the "magic" of many complex adaptive systems. How cruel am I, making them sweat, pay, even die for the opportunity to make me money and not even letting them have sex with each other? Frankly, if the simulations are any indication, they don't need to have sex - yet. They seem to do well without it, and much to my surprise, their useful lifetime is apparently at least 90 years. That said, I'll happily let them have sex and hopefully hear the ka-ching of little evolved trader feet running around - when I get around to the weeks/months of coding required to allow it. The rest of the above, plus some other magic ingredients I want to implement represent months of work. Perhaps by the first of the new year CASTrader II will be ready to go live. I don't want to delay any longer than that.
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