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International Workshop on
Forecasting and Risk Management
IWFRM’06
From Quantitative Finance
To Intelligent Finance
--- Financial Information Fusion,
Multilevel Process Analysis, and
Dynamic Portfolio Management
Prof Dr PAN Heping, Director
International Institute for Financial Prediction (IIFP)
Australia and China, URL: www.iifp.net, Email: h.pan@iifp.net
IIFP China, Finance Research Centre of China (FRCC)
Southwest University of Finance and Economics (SWUFE)
IIFP Australia
School of Information Technology and Mathematical Sciences
University of Ballarat, Mt Helen, 3353, Victoria, Australia
Phone/Fax: +61-3-5327-9860/-9289, Mobile: 0411-489-847
Key Points
• Finance has evolved along a natural sequence of stages
from Economic Finance
through Quantitative Finance
now to Intelligent Finance
These developments are still coexistent and will remain so.
• Intelligent Finance as a science aims to understand the global
financial markets as the world most complicated social complex
systems of intelligent agents – investors, traders and players.
• Intelligent Finance as an engineering aims to develop consistently
profitable trading systems operating in global financial markets –
stocks, bonds, currencies, commodities and their derivatives –
futures and options.
• Intelligent Finance integrates information flows from multiple
perspectives – Fundamental, Technical and Strategic Analysis into a
coherent framework which can help investors/traders to detect,
anticipate and capture profitable investing/trading opportunities in
real time and on multiple time frames, and manage portfolios
dynamically.
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Key Points
Intelligent Finance represents a philosophy that
1. The market is always in a state of swings between efficient and
inefficient modes, on multiple levels of time scale;
2. It is possible to go beyond EMH to study the dynamic evolving
processes of the market between equilibrium, non-equilibrium and
far-from-equilibrium, in multiple dimensions;
3. There are robust dynamic patterns in the evolving processes, most of
them are quite abstract, beyond common sense, and against human
nature, due to bounded rationality, limited resources, and very
human nature of market participants.
4. It is possible to break the symmetry between profit and loss by
exploiting such robust dynamic patterns using a trading system.
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Contents
1. Evolution of Academic Finance vs Professional Finance
- Economic Finance, Quantitative Finance and Intelligent Finance
- Fundamental Analysis and Investors
- Technical Analysis and Traders
- Strategic Analysis and Players
2. Financial Information Fusion (FIF)
- Information Source Identification
- Historical Process Analysis
- Current Situation Assessment
- Future Scenario Projection
- Market Selection and Monitoring
3. Multilevel Process Analysis (MPA)
- Multilevel Fractal Decomposition of Financial Time Series
- Multilevel Structural Time Series Models
- Multilevel Stochastic Differential Equations
- Multilevel Dynamic Pattern Recognition
- Multimarket Multilevel Stochastic Dynamics
4. Dynamic Portfolio Management (DPM)
- Stocks, Bonds, Interest Rates (and Forex Rates and Commodity Prices)
- Influence Factors
- Phases of Trends, Cycles and Seasonality and Market Timing
- Multilevel Multiperiod Portfolio Theory
- Multilevel Value at Risk in General and Extreme Conditions
5. Conclusions and Outlook
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1. Evolution of Academic vs Professional Finance
• Finance to Economy of a nation is like the blood circulation
system and the central nervous system to a living animal body.
Finance not only circulate the money (energy) through the
economy, but also reflects the information about the economy.
• Finance vs Economics are inherently connected, but now quite
different disciplines, each with its own substantially developed
methodologies. It is inappropriate and even harmful to try to
apply economic principles to finance problems. E.g.
equilibrium vs disequilibrium, +- feedback loops.
• Academic vs Professional Finance are inherently connected,
but now quite different schools of thought, each with its own
substantially developed methodologies. Academic Finance
focuses more on financial governance and risk management,
while Professional Finance is more concerned with profit
making while keeping risk checked only as a necessary
condition.
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From Economic Thru Quantitative to Intelligent Finance
• Finance has evolved along a natural sequence of development
stages from Economic Finance through Quantitative Finance
now to Intelligent Finance. Of course these three developments
are still coexistent and will remain so for the foreseeable future.
• Economic Finance refers to the traditional and still mainstream
finance which originates as a coherent part of economics,
including currency, banking and financial markets from
macroeconomics, and corporate finance, accounting and
insurance from microeconomics and business management.
• Quantitative Finance has aimed at quantitative analysis of
every part of finance and developing mathematical and
computational models.
• Intelligent Finance takes the finance of a nation or the whole
mankind as a living complex system made up of intelligent
agents and aims at developing intelligent finance systems for
banking, investing, trading and other financial applications.
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Origin of Quantitative Finance & Problem of Predictability
• “Theorie de Speculation” by Bachelier (1900)
Brownian Motion, Wiener Process, Random Walk
• Efficient Market Hypothesis (EMH) (Fama 1970; Fama &
French 1992)
• Modern Portfolio Theory by Markowitz (1952)
• Super Effective Portfolio by Tobin (1958),
• Capital Asset Pricing Model (CAPM) by Sharpe (1964),
• Arbitrage Pricing Theory by Ross (1976).
A Paradox: A modeling process based on prediction-
free assumptions leads to predicting discrepancies
of the market prices from the model prediction.
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Quantitative Finance, Econophysics, and Socionomics
• Theory of Option Pricing by Black, Scholes and Merton
(1970’s), Long-term Capital Management Company,
Option Pricing and Option Speculation are two different
games.
• Econophysics: Fractal, Multi-fractal, Power Laws, Log-
Periodicity, Criticality, Singularity, Mean Field Theory,
Regularization Group, Minority Game, Minority-Majority
Game, Herding, Financial Bubbles, Super-Geometrical
Spiking, Trend Reversal, Financial Anti-Bubbles, Market
Crashes, Threshold-based Decision Process, Jump
Diffusion, Turbulence, Chaos, Intermittent Chaos.
• Socionomics: Robust Fractals, Elliott Waves, Spirals,
Branches, Fibonacci Numbers, Social Mood, Fluctuation
and Flow Patterns of Societal Activities, History’s Hidden
Engine.
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Schools of Thought in Quantitative Finance
• Financial Mathematics & Statistics
Stochastic DE, volatility, option pricing, time series, GARCH
• Econophysics
Mandelbrot (1967, 1984, 1997, 2004)
Mantegna and Stanley 1999; Ilinski 2001; Bouchaud and Potters 2003; Voit 2004
Sornette 1996, 2003, 2005;
Challet, Marsili & Zhang (2005)
• Behaviour Finance
Shiller 2002
• Computational Finance
Farmer 2002; Farmer and Joshi 2002; Farmer et al 2003; LeBaron 2005
• Long-term Prediction
Campbell and Shiller 1988
Sornette 1996-2006; Zhou and Sornette 2003
Wang et al, 2003-2006
• Short-term Prediction
Lo and MacKinlay 1988
Pan 2003-2006
• Multilevel Process Analysis and Modelling
Pan 2003-2006; Kaufman 2005; Dacorogna et al 2001
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Intelligent Finance – An Introduction
• Intelligent Finance represents an emerging comprehensive
perspective to global financial markets unifying professional
empirical wisdom and art of market analysis and academic
research and science of market modeling.
• Professional Schools include
Fundamental, Technical and Strategic Analysis.
• Academic Schools include
Stochastic Process, Dynamical Systems, and Agent Models.
• Intelligent Finance is a quest for a comprehensive approach,
methodology and system of financial market analysis,
investing and trading, aiming to generate absolute positive
and nontrivial returns of investment by means of exploiting
the complete information about the markets from all
conceivable general perspectives, and simultaneously
minimizing the very last risk – incompleteness of a seemingly
comprehensive investing or trading method or system.
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The key tenet of Intelligent Finance:
Every existing approach or methodology of
market analysis, investing and trading should
be considered a part of the total toolkit (arsenal)
for profitable trading; its effectiveness is time-
varying relative to the state of the art of the
total toolkit currently possessed by the
investing public and to the current market
mode and situation.
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Absolute Positive + Nontrivial Returns
Benchmark Levels of Intelligent Finance
RoIk = (1+10%)(k+1) – 1
RoI1 = 21% Qualification
RoI2 = 33% Buffett (24), Soros (32)
……
RoI6-7 = 100% Day Traders
……
RoI48-49 = 110 x 100% Robbins World Record
Larry Williams, 1987
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How is the world record 110 x 100% possible ?
Weekly Return %: (1+ 1%)52 = 1.68 x 100%
(1+ 2%)52 = 2.80 x 100%
(1+ 3%)52 = 4.65 x 100%
(1+ 4%)52 = 7.69 x 100%
(1+ 5%)52 = 12.64 x 100%
(1+ 6%)52 = 20.70 x 100%
(1+ 7%)52 = 33.73 x 100%
(1+ 8%)52 = 54.71 x 100%
(1+ 9%)52 = 88.34 x 100%
(1+ 10%)52 = 142.04 x 100%
The world record of futures trading = 110.00 x 100%
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The Pragmatic Objective of Intelligent Finance
A Trading System
1) can consistently generate positive and nontrivial
returns of investment
2) with trivial draw-downs
3) at a sufficiently high degree of automation
4) operating in the global financial markets
(such as Medallion Fund and Santa Fe Institute)
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Four Pillers of Intelligent Finance
1) Comprehensive: exploit all the legally available
information about the markets, economies and
societies.
2) Predictive: exploit all the historical patterns from the
existing data and current information to project the
world into the future.
3) Dynamic: assume the patterns are nonlinear and
complex with both stochastic and dynamic natures
and open to the future.
4) Strategic: always be aware of the limitations of
mathematical and computational modeling, react
and act on the strategic intents of strategic
investors.
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Topics of Research and Development
1) Historical Process Analysis
2) Current Situation Assessment
3) Effective Cycles and Seasonality Analysis
4) Future Price Tendency
5) Future Price Volatility
6) Macroeconomic Analysis
7) Microeconomic-Fundamental Analysis
8) Real-time Technical Analysis (Price, Volume, Money Flow, Mood)
9) Automated News Analysis (Politico-Economic-Financial Events)
10) Detecting Profitable Opportunities
11) Trade Planning (Entry, Stop Loss, Profit-Taking Exit, Positions)
12) Portfolio Construction and Management
13) Risk Analysis and Early Warning of Market Crashes
14) Financial Strategic Analysis
(Maker Makers, Minority-Majority Game, Financial Warfare)
15) Global Stock Market Analysis
16) Global Currency Market Analysis (Forex)
17) Global Bond Market Analysis
18) Global Commodity Spot and Futures Market Analysis
19) Global Interest Rate Market Analysis
20) Trading System Development
21) Investment Fund Management
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A Theoretical Framework of Intelligent Finance
(Pan, Sornette & Kortanek, Quantitative Finance, Vol. 6, No. 4, 2006)
1) Stylized Facts of Financial Market Structures and Prices
2) Unified Assumptions underlying Financial Market Prices
3) Financial Information Fusion from Fundamental, Technical, &
Strategic Analysis
4) Multilevel Stochastic Dynamic Process Modelling of Financial
Prices
5) Active Porfolio Management and Total Risk Control
6) Financial Strategic Analysis and Intelligent Agent Modelling
7) Dynamic Optimization
8) Objective Prediction and Intelligent Trading Systems
9) Macrowave Investing and Multifractal Trend Following
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Three Major Research Directions of Intelligent Finance
• Financial Information Fusion
• Multilevel Process Analysis
• Dynamic Portfolio Management
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2. Financial Information Fusion
• Multiple Information Sources
• Multiple Analysis Perspectives
• Multiple Levels of Time Scale
• Multiple Classes of Assets
• Multiple Markets
• Multiple Nations and Regions
Lead to
• Many Profitable Opportunities
• Many Sources of Risks
• Too Many Things to Consider
• Where Do We Start and End?
• How Do We Streamline
Information, Decision and Execution?
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Multiple Perspectives of Financial Markets
1) Fundamental Analysis
Value, Growth, Price, Margin of Safety, Market Shocks, Business Cycles,
Industry Trends and Life Cycles, Competitive Advantage, Management
Quality, Financial Health and Efficiency …
2) Technical Analysis
Price, Index, Trend, Market Cycles, Price Waves, Swings & Momentum,
Support & Resistance, Market Timing, Time Frames, Volatility Breakout,
Stop Loss, Trendline Break, Trend Reversal …
3) Strategic Analysis
Venture Capital, Public Listing, Liquidation, Market Makers,
Accumulation, Lifting, Distribution, Dumping, Currencies-Stocks-Bonds,
Takeover, Macrowave Investing, Conscious Reflexivity Process Investing,
Market Catalysts, “Shark School”, “Wolf Pack”, Stop Running Game, …
4) Mental Analysis
Survival of the Fittest, Your Personalized Trading System, Trade your
System Carefree, Follow your System Religiously
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The Pyramid of Financial Market Analysis
Strategic
Analysis
Scale Gap
Mental Analysis
Psychological Gap
Technical Analysis
Marketplace Gap
Fundamental Analysis
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All Master Investors are Complete Master
1) Warren Buffett is not only the world greatest
Fundamental Analyst and Investor (value & growth,
long only), but also he had learned the essentials
of Technical Analysis even before he started
attending Benjamin Graham’s class at his 20s.
2) George Soros has been the world greatest Trader
with a mix of short and long strategies, profiting
from testing conscious hypotheses on reflexivity
processes on macroeconomic and international
financial events, exhibiting FA, TA, & SA.
3) Both Warren Buffett and George Soros share a
same complete set of mental habits for consistently
winning investment and grand-scale success.
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Practical Exemplars of Intelligent Finance
1) Use Macro-Fundamental Analysis (global macroeconomical and
financial macrowaves, business cycles, leading stock market cycles
and sector rotations) to select international stock markets, bonds,
currency pairs, commodities.
2) Use Micro-Fundamental Analysis (stock valuation, growth
prospecting, competitive advantage, financial efficiency,
management quality, …) to select stocks.
3) Use Macro-Technical Analysis (stock market index and sector indexes)
for market timing and macro-portfolio planning.
4) Use Micro-Technical Analysis (daily charts, realtime intraday charts
and live quotes) for trade timing.
5) Enter the Market using intraday charting and tactics with stop loss
protection.
6) Hold the Position and Follow Trend in motion with trailing stop loss.
7) Exit the Market when either fundamental or technical criteria for
profit taking or stop loss are met.
8) Manage General Portfolios (long and short) dynamically according to
phase and strength of trends and risk management principles.
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A Masterpiece by John Templeton, 2000-2001
Shorting NASDAQ with a trigger – before the end of lock-up period
5500 IXIC (2,073.01, 2,168.11, 2,067.69, 2,163.95, +106.240), pp+ (demo) :: Pivots *, Parabolic SAR (2,012.78) 5500
5000 5000
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1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
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IXIC (2,157.14, 2,165.47, 2,138.45, 2,163.95, +6.33984), pp+ (demo) :: Pivots *, Parabolic SAR (2,060.43)
5000 5000
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Apr May Jun Jul Aug Sep Oct Nov Dec 1999 Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2000 Mar Apr May Jun Jul
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A true story about John Templeton, told by Mark Tier 2004, 2006
Throughout 1999 until 13 March 2000, dot-com
stocks zoomed to absurdly high levels.
Many value investors, realizing these stocks were
wildly overvalued, shorted them all the way up.
This included some legendary money managers.
Having shorted even a bit too early before the peak
could cause unlimited losses.
E.g. Julian Robertson eventually couldn’t bear the
pain any more and quit in disgust, shutting down his
fund entirely. (Soros took some painful loss too).
However, John Templeton, at the tender age of 87,
made a brilliant and enormously profitable foray back
into the stockmarket.
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Three months before the NASDAQ peaked, he
discovered a “trigger” that allowed him to initiate one
of the most creative short selling strategies ever
devised.
The venture capitalists and insiders who floated these
internet companies were typically restricted from selling
their stock until six months or a year after the company
had gone public.
Templeton’s insight was to use the end of this lock-up
period as his trigger.
He systematically initiated short positions in 84
different dot-com companies 11 days before the lock-
up period for each stock expired.
18 months later, he’d added $86 million to his wealth.
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During the Internet bubble and anti-bubble
Fundamental Investors missed
Technical Traders lost
But intelligent speculators made money
- Integrate Fundamental, Technical and Strategic
Analysis (like John Templeton)
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A Framework of Financial Information Fusion
Strategic Intelligence Market Maker Situation &Intent
Stock Price Prediction
Stock Price Situation Analysis
Market Activity Events
Sector Situation Analysis
Trading System
Politico-Economic Events Strong vs Weak Stocks
Index Situation Analysis
Market Price Data
Company Value & Growth
Sector Index Prediction
Company Fundamentals
Industry Cycle & Sector Rotation
Fiscal Policy
Interest Rate & Yield Curve
Market Index Prediction
Macroeconomic Indexes Growth Trend & Business Cycle
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An Empirical Model of Business Cycle, Stock Market Cycle and
Sector Rotation (ref: Navarro, 2004 and macroeconomics textbooks)
Stock Market Sectors
1 – Transportation
2 – Technology
3 – Capital Goods
Business Cycle 4 – Basic Industries and Materials
5 – Energy
6 – Food, Drugs, Health Care
Stock Market Cycle 7 – Utilities
8 – Financials
9 – Autos, Housing, Consumer Cyclicals
Top Peak
5 6
4
Bear
Bull
3 Recession
7
2 Expansion
8
1 9
Bottom Trough Bottom Trough
time
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source: www.martincapital.com
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Economic Indicators Most Sensitive to US Stocks
(Bernard Baumhohl, 2006)
Rank Indicator
1 Employment Situation Report (Payroll Survey)
2 ISM (Institute for Supply Management) Report – Manufacturing
3 Weekly Claims for Unemployment Insurance
4 Consumer Prices
5 Producer Prices
6 Retail Sales
7 Consumer Confidence and Sentiment Surveys
8 Advance Report on Durable Goods
9 Industrial Production
10 GDP
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Economic Indicators Most Sensitive to US Bonds
(Bernard Baumhohl, 2006)
Rank Indicator
1 Employment Situation Report (Payroll Survey)
2 Consumer Prices
3 ISM Report – Manufacturing
4 Producer Prices
5 Weekly Claims for Unemployment Insurance
6 Retail Sales
7 Housing Starts
8 Chicago Purchasing Managers Report
9 Industrial Production/Capacity Utilization
10 GDP
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Economic Indicators Most Influential to US $
(Bernard Baumhohl, 2006)
Rank Indicator
1 Employment Situation Report (Payroll Survey)
2 International Trade
3 GDP
4 Current Account
5 Industrial Production/Capacity Utilization
6 ISM Report – Manufacturing
7 Retail Sales
8 Consumer Prices
9 Weekly Claims for Unemployment Insurance
10 Productivity and Costs
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source: money.cnn.com
Monday, 21 Tuesday, 22 Wednesday, 23 Thursday, 24 Friday,
25
Economic Economic Economic
US - ICSC-UBS Store US - MBA US - Durable Goods
Sales (wk8/19 , 2006) Purchase Orders (Jul , 2006)
Applications
US - Redbook (wk8/19 , (wk8/18 , 2006)
2006) US - Jobless Claims
(wk8/19 , 2006)
US - State Street Investor US - Existing
Confiden (Aug , 2006) Home Sales (Jul ,
2006) US - New Home Sales
(Jul , 2006)
US - EIA
Petroleum Status US - EIA Natual Gas
Report (wk8/18 , Report (wk8/19 , 2006)
2006)
US - Money Supply
(wk8/14 , 2006)
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3. Multilevel Process Analysis of Financial Prices
Why ?
Heterogeneous Dynamic Market Hypothesis
How ?
Multilevel Stochastic Dynamic Process (MSDP)
Models of Financial Time Series
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Facts and Assumptions underlying MSDP Models
(Dow 1880’s, Graham 1930’s; Elliott 1930’s,
Mandelbrot 1970-2004; Peters, 1991; Dacorogna et al, 2001; Pan 2003-2006)
1) Heterogeneous Market Hypothesis: Market participants are not
homogeneous; there are producers, hedgers, investors, traders and speculators;
different participants react to the same information in different ways with these
characteristics:
- Different participants have different time horizons and dealing
frequencies;
- Different participants are likely to settle for different prices and
decide to execute their transactions in different situations,
so they create volatility;
- The market is also heterogeneous in industrial and financial
sectors and in the geographic location of the participants.
2) Fractal Market Hypothesis: Different participants with different time
horizons and dealing frequencies share the same human nature, consequently
the market prices exhibit a fractal structure.
3) Dynamic Market Hypothesis:
(Swingtum Market Hypothesis)
The fractal market prices exhibit robust stochastic dynamic patterns in
the scale space of time and price, which can be described in terms of
multilevel trends, swings and momentums.
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Multilevel Stochastic Dynamic Process (MSDP)
Models of Financial Time Series
Multilevel Chart Reading – Unconscious Competence
(MSDP - MCR)
Multilevel Fractal Decomposition
- Top-Down (Fractal-Preserving Generalization)
- Bottom-Up (Hilbert-Huang Transform)
(MSDP – MFD)
Multilevel Structural Time Series Models
Multilevel Stochastic Differential Equations
Multilevel Dynamic Process Patterns
(Super Bayesian Influence Networks – SBIN)
(MSDP - Models)
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4. Dynamic Portfolio Management
Stationary Portfolio Theory
Arbitrage Pricing Theory
Dynamic Portfolio Theory
Factors and Models for Stock Returns
Factors and Models for Bond Returns
Factors and Models for Interest Rates
Factors and Models for Currency Exchange Rates
Factors and Models for Commodity Prices
Multilevel Phase Reconstruction and Market Timing
Multilevel Multiperiod Portfolio Theory
Multilevel Value at Risk Theory
(general vs extreme conditions – bubbles vs crashes)
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A Trading System Must Be Personalized
E.g. Pan Swingtum Trading System
Human Intelligence:
Swingtum Principles for Expert Trader
Swingtum Principles for Master Trader
Swingtum Trading Strategies
Swingtum Trading Time Windows
Swingtum Trading Signals
Computational Intelligence:
Swingtum Prediction System
Swingtum Trading System
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5. Conclusions
Finance has entered the era of Intelligent Finance out of a 100-years
history of investing, trading, thinking and research.
Intelligent Finance provides a comprehensive approach to break
through the Efficient Market Hypothesis to study the multilevel swing
processes of market equilibrium.
Human being and the world are not chaotic, so there are invariant
patterns, though maybe highly abstract and deeply hidden, in the
market price behaviors, embedded in the economic dynamics.
Financial Information Fusion and Multilevel Process Analysis make it
possible to break the symmetry between profit and loss on multiple
time frames.
Dynamic Portfolio Management provides a natural way to realize this
possibility through a complete operational loop.
Intelligent Finance in general, are still at its early phases of research
and development. Much remains to be done.
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Pan Swingtum Principles
For Expert Trader:
1. Survival of the Fittest
2. Enter Your Zone of Freedom
3. Avoid the Markets of Your Disadvantage
4. Be Practical
5. Be Empirical
6. Keep It Simple, Stupid! (KISS)
7. Trade Carefree
For Master Trader:
8. Only Trade High-Probability Events
9. Invest First, Investigate Later
10. Exit First, Analyze Later
11. Concentrate with Minimal Diversification
12. Ride Reflexivity Process Consciously
13. Use Leverages, but Judiciously
14. Follow Your System Religiously
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Read my motto
Before entering the market
Everyday
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Pan Swingtum Daily Reading (Motto)
My God, show me the big way, give me the big morality and
big wisdom
1. Follow the day trend first thing first, keep a distance.
Don’t be addicted to technicalities,
remain natural, return to nature.
2. Every time when you trade, think as if you are standing
on the verge of a cliff; you strike back either to win or
to die. Therefore, you must have infinite patience, but
when you move, move decisively.
3. Remain tranquil and empty your desire.
Do nothing most of the time,
waiting for the right moment.
Take no action until you see the trend emerge;
Enter with daylight.
4. Follow trend in motion with trailing stop loss.
Make your decisions and take your responsibility.
Survival of the fittest, not the smartest, not the coolest,
not the prettiest. Leave your ego behind when entering
the market. Always have your respect to the market,
befriend with the market, dance with the market.
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The End.
Thank you for your attention!
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