[MUSIC] Learning outcomes. After watching this video, you will be able to understand what parts of an academic paper are relevant for trading strategy. You will also understand how to comprehend the relevant part of an academic paper. [MUSIC] Welcome to this module on trading strategies. I'm assuming that by now you're familiar with basic accounting concepts. You know some market terminologies like what do you mean by shorting a stock. You know some basics about spot and derivative markets, futures and options. Not that you need to know all these in detail for actual trading, but understanding your basic terms will help. So with this assumption I'm going to proceed. So we want to start now with how to read an academic paper. You may be wondering, why do you need to know about reading an academic paper in a trading strategy course? The answer is, source of ideas, source of trading ideas is going to come from academic papers. Why are we doing this? This is because there is a wealth of ideas which are there in academic papers, which have not been exploited by market participants. People do value investing, people do growth investing, people do technical analysis, people do nowadays text mining, a lot of things. But there are low hanging fruits which are available, which academicians have published. This is there in the public domain and you will not have some private information, but these ideas haven't been fully exploited by market participants. By undergoing these course, you will know which are those ideas are. That's the first point. Second, you will also learn to think in those lines and improvise on those strategies. You can create your own strategies based on the ideas which come from these papers. Third, we have the regards in which we hold these economic papers is so high that it's very close to causal. Now, what do I mean by causal? Two variables moving together does not necessary mean that one is causing another. All of us understand that, right? But in these academic papers, these authors try to show that what they are claiming. The relationship between two particular or two or more variables is as close to causal as positive. All the perfectly, no one can say that anything is causal. So that is why the replicability of these ideas, the chance that these ideas work is much higher than a normal strategy that come from some data mining exercise. What we mean by data mining exercise. So if you're good at programming take past data, try thousand times of different type of strategy. A simple type of strategy, any stock which fell 5% the previous day on some x percent the previous day you will buy. This could be one simple strategy or something which went up 1% previous week, you will buy or sell. Whatever. So if you try thousands of such strategies, purely because of chance, that you will find that some strategies work. Now if you start putting your money in those strategies, you may be in for disaster. Whereas strategies that come from academic papers, based on academic research. These are strategies which have been devised by scholars and experts in these areas and hence these are not pure data mining exercises. There is an economic logic as to why these strategies work or why they don't work. And the author also defines the circumstances under which these strategies work. Now does that mean that you can always make money? We have reminded you right at the beginning itself. This course does not guarantee that you just read, undergo this course, you go trade tomorrow and you start making money. No, that's not guaranteed. But then what can we say with high level of confidence that these strategies work better than most of the data mining exercises. And more importantly, this way of thinking that you will get from these papers, that's going to help you devise your own strategies. And the chances of success of those strategies are even higher. Because there will you combine your practical experience with this rigor. That will make a very good combination. So, let me re-emphasize again, don't think that you'll just undergo this course, and from next day you'll start making money. That's not going to happen. It may happen for some of you, but that's not our purpose. That purpose is the students who learn these strategies should be able to apply and also improvise and more importantly incolgrate this rigorous way of thinking about creating strategies. These are really strategies which have economic infusion. There is some reason why these strategies work. So that's the purpose of this course. Now how are we going to go through this model? So let me tell what are we going to do in the next couple of parts. Of course, you have the facility of pausing at any time, that's the beauty of this medium. But what we want to do is that first, we want to do give an outline as to how our academic paper is structured. It's very important. There are large numbers of strategies that have label out there, in the public domain. So obviously in this limited time, I won't be able to cover all strategies or I'll be able to go really few of them, but then I will point out sources where you can get readable more services. One major challenge that you want to come here, is that all these papers tend to be highly technical. What do I mean by technical? These papers already done with a scholarly audience in mind. These papers are not written for general audience. So the writer assumes that a reader has some level of understanding. And more importantly, a writer also assumes that the reader is up to date with the existing literature on that data. So if you pick up any paper, you will see large number of citations of other papers. Now, does that mean that for trading, you will have to go through all those papers, take a five year accounting course, take a five year finance course, and learn mathematics, statistics? The good news is no. And that is what the purpose of this module is. What we want to do is that in this dense jungle of an academic paper, we will try to pick up exactly those parts which are required for understanding the trading strategy that comes out of the paper, and implementing it. And also understanding how the paper, how the strategy has performed in the past. That's the purpose of this one. Okay, so let's start. So, instead of picking some paper which we are not going to use, let's start with a paper that we will use in this course. So this is a paper by Joseph Piotroski. This paper is published, I repeat, published. This is in the public domain. So there is no secret recipe out there, which you will not be able to get. This is fully publicly available. It's a paper by Piotroski about value investing. So you can see on the screen the exact title of the paper. You can also see where the link that you can see where the paper is available publically. So this is published in Journal of Accounting Research which is a top journal in the area of our country. The idea of the paper is very simple. You would have heard about value investing. I'm sure most, if you're interested in trading you have already heard about value investing. Or you would have heard about Warren Buffett for sure. What these people do? Value investors generally pick up stocks which are neglected by the market. And by the amount of time, and they're valued very, very low when compared to their intrinsic equal, intrinsic price. And then hope that these stocks, the market will realize sometime that these were good stocks. And then the prices go up. And that's how they make money. Another question comes. Why markets neglect these stocks? How do you identify these stocks? And, how do you trade these stocks? Now, what Piotroski's paper does is try to, the paper gives you an algorithm to identify a subset of stocks within this value stocks, which are likely to outperform others. That's what this paper does. Now why don't you pick up all value stocks, and just buy and hold. Can you make money, is the question. You'd ask yourself, if that was so easy, if we can just pick up stocks that are valued low, then why are there only so few successful value investors? All of us who have become value investors. Just take a list of stocks, look at stocks which are valued very low. I'll come to this point, that how do you see that a stock is valued low or high? Assume that there is a way of finding it out. Then just pick up those stocks which are valued very low and just buy them and hold, and you make money. You don't need to do, you can party for rest of your life, if it was so simple. As you guess, it's not that simple. Financial economists have pointed out, including nobel laureates like Eugene Farmer and others. The reason why these stocks are valued low is because many of them are on the verge of bankruptcy. There are serious problems for these stocks. Some of them may have liquidity constraints. Some of them may be on the verge of default. Some of them maybe making losses, and so on, and so forth. And some of them may have governance problems. Then numbers maybe saying something, accounting numbers may be projecting a lousy picture, but there maybe some scandals going on. We have had numerous instances like this. Some of them may be taking risks with the market which a lot of people may not realize. So that may be one of the reasons why these stocks are valued low. Now if you buy all these stocks and if you tend to buy such stocks just because they are valued low you may end up losing all your money. And that's precisely why we are very few Warren Buffets. We don't have too many of them. So now, what Piotroski does is within these universe of low value stocks, how to pick up those stocks which are likely to be potential winners? That's the question that Piotroski tries to answer. And more importantly, he gives you a specific formula. Now, if I can tell you right this is a skill. If I tell you it's a skill then there is no answer as to how do you acquire that skill. This is not like painting, and drawing, and music, and all that. Piotroski gives you a specific formula. Does that mean that you just have to know that formula and there is no score for skill? No, not at all. That's not what I mean. What I mean is by understanding this Piotroski's paper, you will get a specific formula to start with. You'll get a screen. Basic screen. And from there you can build on. So there's a score, the Piotroski score, which is called the F score. That tells you whether you have to buy or sell a stock right? So that's the starting point. Now what we want to do in this module is take you through different sections of a paper, of course, we are going to use Piotroski's paper. Why burden you with another paper which you aren't even going to use? And tell you suppose you're given a paper how do you look at that particular area or part of the paper that contains what you want? The meat of the paper so to speak. A paper, typically it has some 60 to 70 pages. You will have around typically 30 pages of text, some 20 pages of tables and some 5, 6 graphs. That's how you will see in a paper. As I told you before, the author's purpose is to publish this paper in a peer-reviewed journal. So there are referees who look at this paper, ask questions. They say that they ask the author to explain how this works. They come up with alternate explanations. The author has to show that the paper is robust to these kind of alternative explanations and so on and so forth. What it mean is there are a lot of parts of the paper which are not essential from a trading point of view. Of course, I encourage you to read the paper fully, understand the paper fully. Some of you may get interested in pursuing a PhD. That's an unintended consequence. That's great. But purely from a training point of view, you do not need to read the entire paper. So first let me tell you how a paper is structured.