Tuesday, May 25, 2010

Guide to Day Trading, Volume 1

Conventional wisdom says that the movement of stock prices is a random walk. Roughly speaking, at any given time, the likelihood that the price will rise is equal to the likelihood that the price will drop.

However wise this conventional wisdom may be, it cannot be completely true. For one thing, the price of a stock cannot drop below zero even though a random walk can. Likewise, it is possible that there exists some kind of upper bound on the stock prices. Unlike the lower bound (zero), this upper bound is unknown. The nice thing is that if stock prices go higher than we've ever seen them before, at least we're not losing money, using the strategy I'm about to describe.

The following plot shows the simulated price (1000 observations) of an imaginary stock that starts out at price = 50. The up-and-down price movements are random but biased. The bias is designed so that when the price is below 50, increases in the stock price are slighly more likely than decreases, and when the price is above 50, decreases are slightly more likely than increases.


The horizontal dotted lines are drawn at Price = 40, 45, and 50. Here is the strategy:
  1. Set aside 40 + 45 + 50 (dollars, any unit of value ... ) for stock investments. Put this money into three funds: 40 in fund A, 45 in fund B, and 50 in fund C.
  2. Whenever the price of the stock hits 40, buy it using the funds from fund A (if available).
  3. Whenever the price of the stock hits 45, sell it (if you own any), putting the proceeds in fund A. At the same time, buy it, using the funds from fund B (if available).
  4. Whenever the price of the stock hits 50, sell it (if you own any), putting the proceeds in fund B. At the same time, buy it, using the funds from fund C.

This strategy could seem silly at first glance. Why would anyone buy and sell stock at the same time? In practice, maybe I wouldn't, but nontheless this strategy illustrates the potential to make money off the of the stock market based on volatility alone. Note that the ending price of the stock is about the same as the starting price in the plot. But if you count up the number of times that you buy at 40 and sell at 45, and the number of times that you buy at 45 and sell at 50, you notice that the profit is about 80.

There are several reasons why it is not so easy to make this work in the real stock markets. The success of the strategy depends on stocks rising and falling again with sufficiently high frequency and also depends on the long-term stock price swings being reasonably small compared to the short-terms price swings.

0 Comments:

Post a Comment

Links to this post:

Create a Link

<< Home