What Time Frame Should You Use When Trading?

by: Logan Kane
Summary

Traders often disagree about whether the market should go up or down, but sometimes they're both right though on different time frames.

Shorter-term strategies tend to have higher risk/reward ratios, but long-term strategies are more stable.

Picking the right time frame is crucial to your success in the financial markets.

choosing the ideal timeframe to trade stocks

Choosing the right investment time frame for your personality and goals can help you be a better investor and helps ensure that you make money over the long run.

For example, if you're an index fund investor and the market drops 20 percent, the long-run return of the S&P 500 typically rises 1-2 percent with the newly lowered valuation. However, if you're a trader who trades on a 1-month time frame, your worldview might dictate that you stay out of the market until the trend turns up again, as history shows that equity markets tend to trend and waiting until volatility subsides to buy produces superior results. Both traders here are likely correct in their forecasts but over different time frames. In this article, I'd like to provide an overview of common investment time frames and how to choose one (or more) time frames to suit your needs.

1. 1+ year time horizon

The most common time frame for investors is to hold for longer than a year. The idea for investing over a long time frame is that you can reasonably forecast asset class returns based on historical returns. Long-term investors usually seek to profit from structural asset pricing inefficiencies or risk premiums, like the value premium, the size premium, or simply from the equity risk premium of owning US stocks.

One year is an advantageous time frame to hold equity investments for because of the lower capital gains tax applied to investments held for at least one year. On average, tax rates for long-term capital gains are one half of those for short-term capital gains. It actually takes a fair deal of forecasting strength to overcome the passive tax advantage of long-term investing (although futures traders benefit from favorable tax treatment also).

Historically speaking, passive investments in stocks outperform cash in roughly 2 years out of every 3, and the odds of success rise a little with each additional year of time frame. Good equity investors aim to improve their risk/return characteristics also. A good goal (but hard to achieve) for long-term investors is to achieve a long-term Sharpe ratio around 1, which corresponds to beating the cash return in roughly 84 percent of years. Some sample ideas for how you can help achieve a higher Sharpe ratio at this time frame are using factor analysis (value, volatility, quality, etc.) and risk parity.

Pros

  1. You need less than $500 to get started with long time horizon strategies. For example, if you use Vanguard and only invest in ETFs, you won't have to pay commission.
  2. If you're patient enough, you can be almost certain that you will turn a profit from your investments.

Cons

  1. You're more likely to have down years than a good trader is, and you suffer the risk of temporarily losing 40-50 percent of your net asset value in a bear market.
  2. Your drawdowns are likely to come during the same time the economy weakens, meaning you're more likely to lose your job or suffer losses in your business at the same time your investments will be down. Strategies that don't have such a high correlation with the business cycle avoid this.

2. 1-week to 3-month time horizon

Another common time frame is to trade from anywhere from 1 week to 3 months. Medium-term strategies usually seek to profit from inefficient trading by other investors causing supply and demand to get out of whack, or from constraints and biases of other groups of investors. Shorter time frame strategies are desirable because you often can trade in the opposite direction of your long-term investments when your forecasts tell you they're likely to underperform (i.e., going risk-off during periods of high equity market volatility), and have more opportunities to make profitable trades than a pure buy-and-hold investor. Even if you’re trading on a relatively short time frame, sometimes you can ride a strong trend for a year or longer by rolling over positions and/or holding until the trend breaks.

1 week to 3 months is the general time frame for most mean reversion, momentum/trend-following, and volatility-targeting strategies. For example, commodities traders like to trade mean reversion on things like soybean crush spreads and crack spreads. Professional equity traders often like trade long/short statistical arbitrage strategies over similar time frames, and options traders often like to trade implied volatility over 1-week to 3-month time horizons. Why do so many traders focus on these time horizons and not longer or shorter time horizons?

Longer time frames often don't make as much sense because strategies that don't make a lot of bets tend to have higher volatility compared to their returns and still don't benefit from the tax benefits from holding at least a year. Shorter-term strategies are hard to make work due to transaction costs. The shorter term a strategy trades, the higher the transaction costs tend to be relative to the profit generated. This matters because if your strategy stops working, your total transaction cost is the average amount you can expect to lose.

To give an example rooted in sports, let's say I develop a factor model for picking winners in the NFL. If I have a strong forecasting ability, my average winning percentage might be 55 percent. However, on each bet I make, I have to pay 4.5 percent commission to the sports book at -110 juice. Therefore, my profit from the system would be 55 X 100 minus 45 X 110, or $550 for the season. To this point, If I make 100 bets a per season at $110 per game, I could expect to lose $500 on average per season if my model stops working. Stocks aren't much different, except that the transaction cost isn't 4.5 percent of wagers like it is for NFL, but rather, is usually thought of as being equal to the bid/ask spread for each round-trip trade, plus commissions. This matters if you trade on a medium-term time frame, but if you turn over your portfolio 50+ times per year, as many day traders do, transaction costs are your number one obstacle to turning a profit.

Also important to know is that the bigger size you trade, the greater the effect of market impact transaction costs on your investment returns.

Source: Journal of Portfolio Management

Here's an example of how the profit from a strategy might look when different transaction costs are applied based on the size of AUM invested in the strategy.

Source: Wilmott Magazine

For those interested, here's the source article as a downloadable PDF.

The advantage of trading in a 1-week to 3-month time frame is you have more opportunities to make forecasts over the course of each year than a longer-term investor, but trading costs are still relatively low compared to your ability to profit from moderately strong asset price and volatility forecasts. A good goal for trading several shorter time frame strategies is to get an overall Sharpe ratio of about 1.7 (2.0 if you're really good). A Sharpe ratio of 1.7 corresponds to a roughly 95 percent chance of besting cash in any given year. Most investors aren't used to this kind of performance because they aren't very diversified and concentrate all their risk in equities. That doesn't make it impossible to do much better than the average investor, however. The main risk from running multiple strategies over any time frame is that your strategies all end up being correlated in times of market stress, meaning you aren’t diversified. To manage this, you need a solid understanding of how each strategy is likely to behave in an equity bear market. Strategies that trade US Treasuries tend to cover for "risk-on" strategies, for example.

Some medium-term strategies that I've found to work include momentum strategies in various asset classes, using moving average signals to trade equity and high-yield bond ETFs, Treasury future carry trades and FX carry trades.

Pros

  1. There are a lot more short/medium time frame strategies than there are long time frame strategies, so you can be more diversified than a long-term, long-only investor.
  2. You get significantly higher reward for the level of risk.
  3. 1-week to 3-month time horizon strategies can hedge or can be otherwise complementary to your long-term investments.

Cons

  1. It's difficult to run medium-term strategies with small amounts of capital. You usually need $100,000+ to play ball.
  2. When you run strategies that aren't perfectly correlated with equities, you can suffer losses when other investors are making gains. This is favorable from a game theory perspective, but is psychologically hard.
  3. If your forecasts are weak, you won't make very much money. Trading shorter term will punish weak traders more than long-term investments punish weak investors.

3. Intraday

Due to transaction costs, shorter time horizons are the hardest to consistently turn a profit from. The absolute hardest time frame to make work is intraday, meaning day trading and not holding positions overnight. However, there are a fair of amount traders who do consistently make money from trading on a short time frame. Market makers and high-frequency traders make envious amounts of money from short-term trading in stocks, futures and options. The main advantage of intraday trading is that you often can get a high risk/reward from doing it because you get to make tons of bets, and if you have a slight edge on each, profit is all but guaranteed once enough independent bets are made. Short-term strategies typically make their money by providing liquidity to the market (like market makers) or by predicting short-term trends in stocks, which can happen when institutions need to buy and sell large quantities of stock. Controlling costs is crucially important for traders who run their businesses on this time frame.

It isn't uncommon for market makers and HFT traders to have Sharpe ratios in excess of 5, meaning they are expected to make money in over 99.9 percent of years. However, such strategies often have low capacities (meaning you can either only make a few million per year from doing so, or that market dislocations/opportunities only arise every so often). This is great for floor traders but not great for funds with $1,000,000,000+ under management. Short-term strategies like this require you to invest in trading infrastructure like colocated servers, $10,000+ per month in data, buying exchange seats, etc. You're also likely to need to be glued to your screen during trading hours in case your algorithms go haywire (like the fiasco that almost bankrupted market-making firm Knight Capital).

It is also possible for such strategies to become saturated with competition and stop working, in which case you need to find new strategies to replace the old ones. All of these factors can cause losses. 90 percent of the effort on Wall Street is expended competing with the other very smart people who trade for the short term, usually in the equities markets. Most people reading this will find better opportunities over longer time frames ranging from a week to several years.

Pros

  1. Intraday traders can use higher leverage because they don't hold positions overnight. This multiplies profits.
  2. Because they make so many bets, it's relatively easy to see whether an intraday strategy is working. If your strategy Sharpe ratio was 3 and you start losing money, it's probably not random chance. You can quickly shut down losing strategies by paying attention to this.
  3. Higher Sharpe ratios correspond to an easier time trading for a living (like floor traders, market makers, etc.).

Cons

  1. Commissions and transaction costs will consume over 100 percent of the expected profit from most intraday strategies.
  2. If your competitors have a lower cost structure than you, you're in trouble, because the market is likely to drive profits to below what you need to stay in business.
  3. Increased competition means intraday is the hardest time frame in which to turn a profit.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.