Automated Trading Strategy #76: Renaissance Technologies' secret to success is identifying irrational patterns in human behavior
Part I
Important: There is no guarantee that these strategies will have the same performance in the future. I use backtests to compare historical strategy performance. Backtests are based on historical data, not real-time data so the results shared are hypothetical, not real. There are no guarantees that this performance will continue in the future. Trading futures is extremely risky. If you trade futures live, be prepared to lose your entire account. I recommend using these strategies in simulated trading until you/we find the holy grail of trade strategy.
This is Part I of a two part post introducing Strategy 76.
In Part I, we’re going to look at the type of trading behavior Renaissance Technologies looks for to find opportunities in the market.
In Part II, we’ll look at what causes that behavior, why it happens and how to spot it in yourself to improve your trading (both manual and automated). We’ll also look at how to use what we learned from Renaissance to create Strategy 76 and 77.
Let’s get started…
A little over a year ago I went to the dentist. When he told me that I needed a tooth guard to stop grinding my teeth I laughed—out loud. I was asking for help with tooth sensitivity. How could that have anything to do with grinding my teeth at night? After some research I finally gave in and ordered the guard. It was over a year later, but the issue was fixed almost immediately and I felt truly dumb. What had happened? My ego had become a blind spot; it was working against me. Doing your own research is one thing, but why did it take me so long? Unwittingly, I had sabotaged myself and the consequence was a year of sensitivity and pain that could have otherwise been avoided.
When I went looking for more blind spots in my life, I found many. They were everywhere—these little areas of poor decision making that were actually working against my personal goals in life. Some might even say that the very act of sharing strategies is at odds with finding the holy grail. I’m still debating that one.
What I do know is that we all have blind spots and the market exploits them. One fund in particular has found that the ability to identify areas of poor decision making or high emotion has become their edge. That fund is Renaissance Technologies.
Renaissance Technologies: The Secret Sauce
Renaissance Technologies is one of the most successful hedge funds in the world. Known for its Medallion fund, it started out in futures and migrated to stocks for scale. The hedge fund reported over $69 billion in managed 13F securities as of the end of the second quarter of 2023; with an AUM over $106 billion.
I was hoping to learn a few secrets by reading the book The Man Who Solved the Market: How Jim Simons Launched a Quant Revolution by Gregory Zuckerman. Strategy 76 was inspired in large part by what I learned.
There are several reasons for Renaissance Technologies’ success that I will work into our strategies over the coming year, but the most important one is an understanding for “who’s on the other side of your trades.” One of their researchers joked it was mostly overconfident dentists. The irony of such a revelation is not lost—like I said, we all have blind spots. Here’s an excerpt from the book:
Over time, Simons came to the conclusion that the losers probably weren’t those who trade infrequently, such as buy-and-hold individual investors, or even the “treasurer of a multinational corporation,” who adjusts her portfolio of foreign currencies every once in a while to suit her company’s needs, as Simons told his investors.
Instead, it seemed Renaissance was exploiting the foibles and faults of fellow speculators, both big and small.
Ultimately, Renaissance stopped caring about why. They shifted the focus to what worked. They stopped trying to develop a reason for why things worked and started focusing on what was working and how to do more of it. It may seem like these are the same thing, but the former is a riddle, while the latter is something that can be observed—not every time, but with enough regularity that it can be turned into a strategy. This is not intuitive.
These trends and oddities sometimes happened so quickly that they were unnoticeable to most investors. They were so faint, the team took to calling them ghosts, yet they kept reappearing with enough frequency to be worthy additions to their mix of ideas. Simons had come around to the view that the whys didn’t matter, just that the trades worked.
By 1997, though, more than half of the trading signals Simons’s team was discovering were nonintuitive, or those they couldn’t fully understand.
The team at Renaissance realized that human behavior does not always make sense, but nevertheless, it drives the market. The best answer you’re going to get to the question “why” is “because that’s what happened before”. This is the explanation given in the book by one of Ren Tech’s researchers:
“What you’re really modeling is human behavior,” explains Penavic, the researcher. “Humans are most predictable in times of high stress — they act instinctively and panic. Our entire premise was that human actors will react the way humans did in the past…we learned to take advantage.”
Again, they are bypassing the “why”. Instead, they are looking for cycles and patterns of human behavior in the market.
What are these cycles and patterns of human behavior?
In Part 2, we’ll identify these cycles and patterns, how to spot them in the market, yourself and other traders. We’ll also talk about how we used this information to create Strategy 76.
If you have any questions, please let me know.
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