The Basis of Our Approach: An Edge on the Margins

There is an underlying order with central tendencies to which are curve-fitted comforting narratives. And those narratives are not unlike many popular technical indicators that react to and consequently lag price.

It took us thousands of lines of code, most of which was junked, in an agonizing search for clues that might lead us to an unifying principle that informed central tendencies in stocks, bonds and commodities. And we found one that has served us exceptionally well. The formula was unoriginal and embarrassingly simple and proved stable over 40 years of back-testing. It forms the basis of our approach to trading all instruments. It enables us to marry fundamental valuation factors with high-probability technical entries and exits.

We believe that broad-stroke ‘Macro’ is essentially a suite of lagging technical indicators. So we avoid it like the plague. But, perhaps more importantly, we don’t rely exclusively on Micro factors. We believe both Macro and Micro narratives lag the underlying order driving price and the waffling that is a characteristic of macro bullshit is evidence of one’s being habitually out-of-phase with the central tendency of a given market.

We have referred to the governing force behind price action as the invisible hand, and others have as well. It stands around a corner and casts a shadow in your path. Turn the corner, and it will already have rounded the next one. But it has incidentally given you quite a lot to work with: the shadow. So for every instrument, one must correct for the angularity of the shadow relative to the position of the street lamp that is its cause.

It sounds rather mystical, and I suppose it is, but one still has one’s hard valuation models as jumping-points. One has a rough price in mind at which an issue represents value.

Where, then, is the invisible hand operating relative to one’s assumptions about value?

That’s where the accounting ends and the code kicks in. We simply wait for a signal. It may be a signal to get long that we’ll heed with exuberance — if there is a glaring discrepancy between price and our estimate of value. Just as often, we are signaled to short the very issues we hope one day to buy.

Frequently, our actions contravene the dictates of instinct. To trust our system is to repeatedly neutralize gut feelings, as well as to often override our dearly-held assumptions derived from our valuation models. We want to be right more than 50% of the time, but this requires that we subdue many of the inclinations that make us human. We have to be as good, or better than, the machines against which we are trading.

This means we step in front of price when our system flashes a signal. These signals are infrequent, but when we get them and they flash in concordance with our valuation models, we buy big. Silver, for instance, is within a hair’s breadth of flashing a buy signal. Whereas it has been an aggressive short from $16, according to our system.

We try to be proactive, moving when one’s brain screams, ‘This is counter-intuitive.’ And we are always contrarian, especially as the underlying order appears to possess, essentially, a contrarian spirit. The underlying order seems also to operate with a cold disregard for human action. Coupled with this seeming indifference to the expectations of humans, is price-action that anticipates tomorrow’s narratives.

So, then, is the market efficient? Does the central tendency of price betray not only a foreknowledge of all knowns, but all absolute unknowables, as well? We think so. And we think it is this underestimation of nature — and the supernatural in price — that rips traders to shreds.

We worked hard to find an edge on the margins.

The fiery baptisms were many. We fought countless battles and we lost many of those battles. Then we found a partial differential equation that stood the test of time and enabled us to stop fighting. We would have worried if it possessed properties that prevented its application across unlike trading instruments. But we were surprised by its universality. Only one variable must be adjusted when switching between instruments. And so far, the only instruments that seem not to conform well to the equation are Wheat and Corn, which raises a host of other interesting questions about wheat and corn in particular. Hard Red Winter Wheat does conform, however.

In sum, a system that makes ample allowances for what we don’t understand, which is pretty much everything! More importantly, a system that has the capacity to intersect with prices that represent value, and in some cases, deep value — as we perceive it.

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