Monday, February 29, 2016

Using Intra-Day Models to Improve Tactical Asset Allocation

Just about any form of tactical asset allocation (TAA) will work extremely well in a straight up market and a straight down market.  However, many methodologies will struggle in a choppy market that either has no real trend or that moves so quickly that a TAA strategy just doesn't have time to adjust.  In the past I have written about a number of different ways to improve the way TAA strategies navigate choppy markets, this post will talk about adding intra day models. 

The main reason that TAA works so well is that markets are not random.  For the random walk theory to be valid the day to day movements in the stock market would have to be like a coin flip, where what the market does today has no bearing on what it will do tomorrow.  Markets don't work that way.  They move back and forth between trend following environments, where an increase today is likely to be followed by an increase tomorrow, or mean reverting environments, where an increase today is likely to be followed by an increase tomorrow.  However, in a choppy market the day to day movements do start to become more random in nature and each day becomes less motivated by what happened previously.  At the same time choppy markets tend to be more volatile and the spread between the open price of the market and the close tends to widen out. 

Just like markets tend to trend over longer term time frames, they also tend to trend during the day.  Ghao, Han, Li, and Zhou wrote an interesting paper in 2015 showing that the first half an hour return in the market tend to predict that last half an hour return.

This means that a momentum model can be constructed for intra day trading just like a momentum model can be constructed for longer time periods.  This offers a number of important advantages:

1. In a choppy market there is no real momentum over longer time periods but this should not impact momentum intra day.

2. In a choppy market the risk of holding positions overnight increases, intra day models close out all positions at the end of the day and start fresh the next day.

3. In a choppy market most TAA models would be out of stocks entirely and would not be able to participate in gains on up days.  Intra day models can participate in up days.

Intra day models can substantially improve TAA strategies by allowing them to do better in choppy markets and participate in intra day gains when  they normally would not be positioned in stocks.

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