Scientists create formula for producing better traders

Scientists create formula for producing better traders

Cambridge researchers say that a smart combination of testosterone, experience and profit-sharing incentives - rather than big-money bonus payouts - produces traders who are capable of consistently outperforming the market.

The study by John Coates and Lionel Page of the University of Cambridge builds on previous research that found higher levels of testosterone, in both the male foetus and the adult, predicted higher profitability among so-called 'high frequency' traders, who hold their positions for only seconds or minutes.

In the current study Coates and Page examine a more subtle measure of performance than profits - a trader's Sharpe Ratio. This is the ratio between how much money a trader makes and the amount of risk taken in making that money.

According to Dr Coates, who previously ran a trading desk on Wall Street: "A trader making $100 million would normally be considered a star, but not if the trader could just as easily have lost $500 million. A trader's Sharpe Ratio is a better measure of skill than profits alone because it would expose this trader as reckless."

The authors calculated the Sharpe Ratios for 53 male high-frequency traders in the City of London. They then compared the traders' ratios for the period 2005-07 with the Sharpe Ratio of the Dax, the German stock market and the traders' benchmark index.

They found that experienced traders in the study group (those trading for more than two years) had an average Sharpe of 1.02, significantly higher than the Dax, which averaged 0.53 during the same period. Importantly, in a follow-up they ascertained that the experienced traders performed on average even better during 2008, a year in which many traders at other banks and hedge funds lost more money than they had made in the previous five years.

The out-performance of these traders is unlikely to be due to chance, say Coates and Page, because they also found that the Sharpe Ratios of these traders increased significantly the longer they had traded, indicating that they were learning to be more prudent risk takers.

The study has practical implications for banks and hedge funds which need to know, when allocating capital and bonuses, whether a trader's performance is due to skill or luck, suggests Coates. "Our study suggests a novel way of remunerating traders. Banks could use an improving Sharpe Ratio over time as a measure which reliably indicates a trader has developed a skill worth paying for."

By paying bonuses on profits alone, however, capital markets firms may have encouraged traders to maximise their risk, rather than Sharpe Ratios. "The traders in our study, on the other hand, received no bonus, only profit shares. They had therefore a strong incentive to lower, not raise, the variance of their profits," adds Coates.

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