In our previous column on "quant" investing, we explained the first two elements of design: idea generation and set-ups. We will now elaborate its remaining four elements: entry and exit, stop, position sizing, and portfolio construction.
Entry and exit are designed to define the timing of stock buying and selling, based on stock prices or trading volumes. Entry is a condition to buy, while exit is a condition to sell. For example, channel breakouts are buying signals when the stock price breaks through its resistance or peak price level, whereas the selling signals occur when the stock price breaks through its support or lowest price level.
However, investors should base their investment decisions not only on buy and sell signals, but also on overall market trends and trading volumes.
Stop means to sell, based on conditions associated with the investment return, which fall into four groups:
1. Target profit: sell a stock when a target price is reached.
2. Stop loss: limit an investor’s loss on his or her position in a stock.
3. Trailing stop: a way to lock in profits and limit losses.
4. Time-based stop: a stop loss initiated after a predetermined period has elapsed.
Position sizing is to allocate each investment’s number of stocks to be purchased in order to manage risk by limiting portfolio losses, that is, to minimise damage and maximise the growth of wealth. For asset allocation, investors should invest in various assets, industries or markets.
For position-sizing calculation, investors should concern their own capital at risk in comparison with the risk value of stocks, to be calculated from the stock price minus the stop-loss price.
Portfolio construction is to build an investment portfolio until the optimal investment proportion of all portfolios is established. The returns are based on investors’ need, capital at risk, and transaction cost.
The portfolio-construction model is of two types:
1. The rule-based portfolio construction model is to build an investment portfolio under simple investment rules, such as equal risk weighting, which means investing in high-risk assets in small proportions and low-risk assets in large proportions.
2. Portfolio optimisation is to find an investment with optimal returns based on defined conditions, such as portfolio risk. An example of portfolio optimisation is the Markowitz model, which yields the highest expected return for a given amount of risk.
This is Quant Investing, part 3 , from Investment Risk Department, Asset Plus Fund Management
In our next column, we will explain the last three basic steps of the quant model.