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Then, the system filters stocks based on price-to-book and market capitalization criteria and
a momentum indicator. The system buys the top 50 stocks according to the filter and holds
them for one month.
We then attempt to enhance the portfolio return through a second filter that selects
index options to sell. The system calculates the portfolio beta versus the S & P 500 and
sells the appropriate value of index call options based on a minimum call away return.
The filter selects call options to sell based upon their moneyness.
We will benchmark this trading system against the S & P 500 index and/or the CBOE
Buy Write Index. By selecting better stocks and enhancing the returns through covered call
writing, we will produce a portfolio with better performance characteristics than the index.5.6. Example Signal Strength System:
Multifactor Long–Short
Beginning with the combined S & P 500 and Nasdaq 100 as the investable universe (to
ensure shortability), our multifactor system ranks stocks on a grouped factor, consisting
of the individual factors ’ relative strength, P/E, P/S, and earnings growth rate. (These fac-
tors are widely believed to have predictive ability in the finance literature.) Each indi-
vidual factor is demeaned and ranked by sector and universe. The stocks are then ranked
by percentile and those percentiles are turned into deciles.
The deciles by individual factors will then be combined into an overall universe score
by placing optimized weights on different factors. We will then again rank the overall
score by percentile and again turn them into deciles. In the end, we have ten baskets ide-
ally with the same number of stocks, from which we can calculate a basket return and a
basket volatility. The strategy is to sell the bottom decile and purchase the top decile, a
standard long/short strategy.5.7. Conclusion
In reality few trading systems fit neatly into a single category. Most consist of complex
trade selection, portfolio creation, and risk management strategies that may include con-
cepts from all three categories. While these systems can be complex, the basic building
blocks of the K|V methodology apply to all systems—define, backtest, implement, man-
age. Adherence to a methodology will maximize the value of the firm ’ s portfolio of trad-
ing/investment systems. The only limitation on the K| V methodology is the user ’ s ability
to create the quantitative trading algorithms and performance measurement methods dur-
ing the design and development stages.5.7. CONCLUSION