Managed Futures: IQ vs. SQ
During the last few years, investments in managed futures have increased dramatically and is expected to continue to grow if stocks continue to underperform. A major argument for diversifying with managed futures is to lower portfolio risk. At SentiTrade we provide managed futures using a proprietary trading system that involve going long or short in futures contracts on equity indexes such as the Mini-Dow, Mini-NASDAQ and the German FDAX. They can be booked via a select group of brokers that have been authorized to trade them.
SentiTrade’s trading models apply real time market psychology assessments. Specifically, our computer linguistic algorithms detect tonality in financial news stories, providing a contextual argument for bullish / bearish market trends. Opportunities are identified when the sentiment is either extremely high or low, because it indicates that short term market expectations are unrealistic.
By producing so called Sentiment Quotients (SQ), fixed number values, we can determine the current market psychology. The SQ’s are produced simply by measuring the ratio between positive and negative news items at any given time. Well known behavioral finance principles can thereby be included in our trading models. We identify misplaced risk, implied by overly positive or negative financial news coverage, and eliminate broad unknowns.
This approach directly contradicts traditional economic theory, such as the Efficient Market Hypothesis (EMH). EMH has underpinned modern economic theory and investment strategies for the past 100 years, and assumes that the market is always “right”. However, we then have to accept that market participants (i.e. traders who set the prices) are rational and well informed at all times (the article continues below).
Those of us working with the markets day in and day out, know this NOT to be true. Still, supporters of EMH assume that smart investors can trade against and prevail over the irrational and ill informed by driving the prices to reflect true value. Unfortunately, markets can remain irrational longer than rational investors can remain solvent (Keynes). This implicitly means that optimum portfolio performance is reached by “following the trend” regardless of whether it’s rational or not.
“Rational” and “well informed” financial engineers (presumably with a high IQ level), is surely a good start for creating managed futures strategies. Still, the effort will inevitably will fail if based on EMH alone. Without a SQ there’s no way to account for the element of price associated with human emotions.
And that, we have found, is key for finding whether a short term trend is sustainable. Or not.
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