What have I been working on?

Recently I have been exploring the more complicated aspects to trend following and a purely systematic approach to trading. I enjoy the idea behind a systematic trend following approach to trading, taking out the emotions and doubt. However, before I would even consider attempting this (or any for that matter) approach, I will submit it to a rigorous back-test to ensure it will actually be profitable in the market. For me, this meant making a relatively complicated excel spreadsheet. 

It is still in the works but I thought I would put a draft version up here to see if anyone had any advice for improvements or to point out any mistakes I have made. Currently the spreadsheet is split up into 4 sheets; an Executive Summary page, an Inputs page, a Raw Data page, Dividends, and Calculations page. At the moment most of the work is going into the calculations page where the real magic happens. So far the spreadsheet will take the inputs put into the inputs page (No. days high/low, initial capital, capital at risk) and calculate when a trend is occurring that you would buy or sell. The spreadsheet will then calculate any profits or losses on each trade and give you an updated capital figure. A summary will be displayed on the Executive Summary page that will have a graph of capital over the length of time specified, amount of profit/loss, and a count of how many buy/sell signals occurred over the period.

However, this excel spreadsheet is still incomplete. I have not yet included the dividends as a type of income to increase the capital on hand (as I use the high and lows of the day in my calculations, I cannot use an adjusted figure.). Also I have not yet managed to effectively pyramid the trades to buy more shares as a trend continues, a fundamental part of trend following. Due to these flaws, the macro I have been developing to take the raw data, run the calculations I want and then display all of this information is currently useless. Once I have ironed out these flaws I will create the macro again, which will hopefully work the way I envision it and save me a lot of time. I just hope my computer can handle it as I have had some issues with excel/my computer crashing due to an overloaded CPU (I guess it isn't that unexpected when you are trying to do ~32 million calculations simultaneously!) 

Let me know what you think! 

Capital Structure

A continuation on the topic of capital structures has been demanded by some readers (remember I exist to serve the readers so email your questions to illuminatingfinance@gmail.com). For first time readers make sure you check out this blog post before continuing with this one - http://illuminatingfinance.blogspot.com.au/2014/03/debt-and-equity-capital.html.

Okay so remember that the proportions of debt and equity a firm has outstanding can be referred to as its capital structure. Today we are going to delve a little deeper in the some of the advantage and disadvantage of different capital choices for firms.

One advantage of using some debt in the capital structure of a firm is that it enables them to leverage the equity for an increased investment. In layman's terms this means that it lets them spend more money than the firm has access. Another advantage of firms using debt is the tax benefit derived from the interest payments. Firms are able to deduct interest expenses from their taxable revenues to create a more favourable tax environment.

However, despite the advantages using too much debt has the potential to put the firm in serious financial distress. If a firm who has used excess debt in their capital financing has difficulty meeting its debt obligation (repayments), they may eventually be forced in bankruptcy. Even if the financial difficulty does not spread to the extent that it forces bankruptcy it can still have negative consequences. These may include: loss of customers, loss of suppliers, cost to employees, and fire sales of assets (selling assets very quickly accepting prices that are well below market value).

So now we know some of the main advantages and disadvantages we reach THE question regarding capital financing and capital structures.

'What is the optimal capital structure?'

Or in other words - 'How much debt is too much?’. This question is very difficult to answer in generic terms as it will vary for each firm. In finance there are ratios and calculations that are used to try and estimate the answer to this question. However, in reality the answer is at the point where the probably and magnitude of the firm incurring financial distress outweighs the advantages of including debt in the capital structure.


I'm sorry to end on that ambiguous answer but the answer will be individual for each company. If you would like to know more about the calculations and ratios make sure you email illuminatingfinance@gmail.com (or if you have any other questions!)

What are derivatives?

We are coming to the end of the most popular questions I have been sent recently. So next week we will be back to regular programming about subjects I think may help you more clearly understand finance. This week’s question is based on a finance term that they did not understand (feel free to ask me questions about even the smallest and simplest concepts as I often find they can open up into very interesting topics to explore. Email me at illuminatingfinance@gmail.com).

“I heard someone say ‘floating security over assets’ and had no idea what they were talking about. Could you please explain what this means?”

So the phrase ‘floating security over assets’ does sound quite intimidating, and if you were on your own I wouldn’t blame you for just saying ‘oh forget it’, and moving on with your life. Luckily you have me! Together this week we will explore what this phrase is actually referring to.

So what the phrase is referring to are derivatives. Derivatives are financial instruments whose values depend on (or derives from) the values of another underlying variable, as if they are 'floating' over the asset. Very often the variables underlying derivatives are the prices of traded assets. A stock option, for example, is a derivative whose value is dependent on the price of a stock. However, derivatives can be dependent on almost any variable from the weather to the quality of harvest of a crop.

In recent years derivatives have become increasingly more important and popular in finance. Futures and options are actively traded on many stock exchanges and many financiers enter into forward contacts, swaps, options, and other numerous other derivatives. Primarily derivatives are used to transfer risk from one entity to another, but realistically they can be used for hedging, speculation, or arbitrage.

As usual this is just scraping the surface when it comes to derivatives. Contact me at illuminatingfinance@gmail.com if you would like me to go into more detail. I am sure I will cover this topic in time as this is a very complex and often misunderstood subject.