Hack the market

A reader of this blog (hey – I’m as surprised as you are!) sent me an email recently detailing a strategy they’d developed.  While the details of that strategy aren’t relevant here, they sounded good and they got me to thinking about the process of selling a trading strategy.  This is an activity that I’ve spent some time on and have decided just isn’t for me.

There are a lot of difficulties with selling a trading strategy.  One of them is a consequence of the foundational problem of back-testing about which I first started posting on this blog.  For any given period of time (that has already elapsed!), it’s not difficult to generate a good number of pretty impressive strategies.  All you have to do is try a good enough number of random strategies and some of them will prove to be too good to be true.

Presumably, any credible person who might be listening to your pitch will be at least intuitively aware of this fact and will thus be highly suspicious of any back-tested results you might present.  For this reason, it’s impossible to sell a strategy on the basis of back-tested results.  Only auditable, real-world returns will be considered valid by any serious person.  Of course, you might find someone who’s less particular, but then you’re flirting with fraud rather than a legitimate sale.

So let’s say you have impressive, verifiable results.  You still have to answer the question:

If this strategy is so good, why are you selling it?  Why not just trade it yourself?

I suppose one answer might be that you have insufficient capital, but I just don’t think it’s a very satisfying answer.  It’s hard not to think that everyone can borrow money somewhere or run up credit cards or somesuch.  Another, possibly better, answer might be that the strategy requires more favorable commissions than you can obtain, thus you’re looking for an organization that’s either an exchange member or just trades in sufficient volume to have significantly lower costs than you can muster.  Again, not totally satisfying, particularly given that you really need a track-record to have gotten to this point.

Another impediment to selling a trading strategy is that it’s just an idea and ideas can be stolen.  You have to somehow give enough information to make your story credible, without giving away the strategy itself.  This can be harder than it sounds as the person listening to you presumably knows something about the relevant markets and might have some good understanding about the kinds of strategies that can be effectively deployed.  As a minimum, you have to convey the relevant performance characteristics of the system in good detail.  Even this can be revealing as the returns will often tell a tale about the strategy that generated them.  Additionally, most will want to hear a compelling “story” about how/why the strategy works.  What inefficiencies are the strategy capitalizing on?  This can be even more revealing as it will be in the form of a free-form discussion followed up with questions etc.  In the end, you might find that you’ve told a number of people revealing characteristics about your strategy – enough at least for them to do some digging of their own – without getting any closer to your aim.

But let’s say that you’ve managed to find someone who is interested.  Now the real difficulties begin!  How do you structure the deal?  I suppose you could sell the signals if the system trades sufficiently infrequently, but this obviates the entire class of higher frequency strategies.  It’s also a bit of an asymmetric deal in the sense that you presumably sell the signals on some kind of a fixed subscription basis whereas the purchaser can use an arbitrary amount of capital on the strategy.  In spite of these difficulties, this seems the cleanest kind of deal and I’ve seen it done in institutional contexts, so it’s not beyond the realm of possibility.

Another option, particularly for high-frequency systems or in cases where commission structures or trading infrastructure are a key element of the viability of the deal, is to partner in some concrete way through a partnership or a formalized joint venture.  This, too, is something that I’ve seen and have even engaged in, so it’s not too fanciful, but at the end of the day it ends up being like any other partnership or business: it fundamentally requires a deep level of trust.

(Another possibility, of course, is to wrap the strategy into a hedge fund, etf, structured product or other salable instrument and market it in a normal way.  But that’s another discussion as it requires significant capital upfront which means you could, if you chose, monetize your strategy directly by trading it.  So, it’s really a different issue entirely…)

Thus, if one can overcome the myriad difficulties, it is possible to sell a trading strategy.

That said, I wouldn’t recommend doing it and it’s not something that I’m interested in as a business model.  Why not?  Ultimately, it’s about what interests you and how you want to spend your time. Do you want to be a salesperson and spend your time preparing and smoothly delivering presentations, networking and glad-handing &tc?

Or do you want to research, develop and trade your algorithms?

ultimately, it's about what you want to do...

hedge funds, startup, strategy development