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The Trading Frequency Question

Short term or long term? High frequency or low frequency? There has always been strong opinions on both sides of the argument. The quants say short-term, high frequency trading (HFT) is best due to the magic of compounding and the inherent advantage in cutting losses. But other gurus say that long-term, low frequency trading avoids much of the noise that causes whipsaws, is lower cost in terms of commissions and slippage, and is a better fit with most personal lifestyles.

So what about the actual performance of top traders? Based on publicly disclosed data available on two websites, supplemented with other published information, two distinct trading practices were evaluated by this author in early 2007 and are summarized in the table. First row is a low-frequency style known as long-term trend following. Made famous by the Turtles in the 1980s, most of today's largest CTAs employ this approach. Among the 13 LTTF traders that I examined are five of the original Turtle students and their co-instructor. The current owner of the Boston Red Sox is another one of the LTTF data points.

Second row is a high-frequency style that exploits non-random price patterns and market inefficiencies. It has been equated to card counting in blackjack, with the implication that it's a form of cheating. (In my categorization, this form of HFT differs from the dark pools and automated front-running famously described in Michael Lewis' bestseller Flash Boys.) The most successful of the short-term pattern exploiters is mathematician James Simons of the Medallion Fund and his platoon of PhDs. Two private traders profiled by Schwager and five CTAs are also included in the STPE data.

Real world results by the world's best practitioners point to high frequency systems as superior from an overall risk/reward perspective. Short-term pattern exploiters have demonstrated on average much better returns (over 40% higher) with far less risk (60% lower standard deviation and 80% lower maximum drawdown). System frequency as depicted in the table refers to the number of roundtrips per year trading a single instrument with the basic methodology. It's worth noting that the vast majority of both LTTF and STPE traders employ portfolio diversification and model variations to mitigate risk further, leading to greater trading frequencies across the board. The relative comparison is not affected.

By creating a system that has a truly sustainable statistical edge, and by possessing the psychological makeup to trade it properly, it's possible to become very, very rich. Let's for a moment assume you are a thousand times less able than Prof. Simons, the multi-billionaire. Is it then a possibility that you may wind up with merely a few million?