Luck By Design - Part 3

Taking a Simple Momentum System and Mitigating Luck

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Introduction:

In the previous articles in this series, we examined how luck plays a role within our systematic trading. We examined luck in relation to opportunity and risk for each trading opportunity, and when we diversify our risk across each opportunity, we achieve better outcomes of luck. We also put the concept of luck control into practice with a mean reversion system on a set of ETFs. With that system, we managed to diversify our risk across time, parameter space, and universe to result in better outcomes of luck and a more stable trading system. This resulted in a much more appealing outcome than the non-luck-controlled version of the same system.

In this article, we are going to study another example of implementing luck controls, this time looking at a momentum trading system. The concepts will be similar as before, but we will approach them in a slightly different way tailored specifically to the momentum system. As a result of controlling our luck within this momentum trading system, we will find better performance outcomes and system stability than if we took the traditional binary 0-1 luck outcome.

If you missed the previous article in the series, check it out here:

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System Idea:

Let's introduce the momentum trading system. The baseline version of this momentum system is not special in any way in terms of its rules or implementation. The momentum system we will be working with is a pretty standard way of implementing momentum, no secret sauce or special bells and whistles. With that said, we will eventually make the system special by implementing luck controls. The premise of a standard momentum trading system is to buy the top-performing stocks in a universe, hold them for some period of time, then after the given period of time re-examine the universe and sell any stocks that are lagging in performance and replace them with stronger performers. Essentially, the goal is to periodically update the portfolio such that it’s always exposed to the best-performing stocks. I trade many different versions of momentum within my own portfolio; momentum is one of my favorite trading styles, so I am excited to dig into this system with you. The general rules of the momentum trading system are the following: