What do buying futures on the FTSE top 100 index and rocket science have in common? Apparently not much unless you are a specialist in cryptography and mathematics from Bradford University who has developed a model that predicts how the FTSE will perform.
Dr Simon Shepherd, the head of research in the cryptography and coding research group within the Telecommunications Research Centre at Bradford, spent 12 years in the Royal Navy. "For many years in the MoD [Ministry of Defence] I worked on the guided missile autopiloting and guidance systems," said Dr Shepherd. After leaving the navy he went to Bradford as a specialist in mathematics and cryptography, and coincidentally with a great interest in the stock market. "I realised that fundamentally, the same mathematics that allowed a missile to anticipate a target's movements could be used to predict market movements." He tested this hypothesis by developing a model to predict movement of the FTSE 100 index. His two-year research project used FTSE data going back to 1984, he said, and analysed literally millions of transactions and index movements.
The result is a model that can predict index changes with an accuracy of about 68 per cent, a massive advantage over random predictions which usually achieve no better than a 50-50 result.
"The major problem with adapting the rocket model to the markets is the amount of noise," he said. "Noise" in this case meaning the confounding signals that make market movements so complex. He found, however, that the mathematics used in guidance systems could be applied to filter out this noise and get a better signal - an impression of whether the index was going to rise or dip. "Once you can actually get that right, with a smooth signal you can do something," said Dr Shepherd.
In fact, he did much more than get a signal, he joined with two partners, Mr Mike Loginov and Mr Steven Phillipson to form a new company which is making this technology available to market investors. The firm, Investment Alchemy, began trading officially on February 24th and within a few days was already ahead 16 per cent, Mr Loginov said.
The company, which is trading on the Web as futuresonline.com, is bringing its product to market initially via investment clubs who will trade online over the Web. Investment clubs are a well-established entry to the stock market in Britain and an approach catered for by the market regulator, the Financial Services Authority.
The three decided to target the exotic financial products available via the London International Financial Futures and Options Exchange (LIFFE), in this case futures in the performance of the FTSE 100 index. They do not own FTSE 100 stocks, they only transact futures against movement of the index.
Initially they tested Dr Shepherd's model using two "virtual clubs", Mr Loginov said. During 10 weeks trading they turned £7,000 of virtual cash into more than £300,000 using Dr Shepherd's model.
Dr Shepherd admitted that this return was based on trying to maximise returns and involved much high-risk trading, and said that they are being far more conservative with the real funds assembled and invested by the company's third club, Club 3. This group comprises 12 members including the promoters and a few friends and relations.
The target they have set for returns, however, is remarkable, 15 per cent compounded, giving an annual return on investment of a staggering 570 per cent, Dr Shepherd said. So far they are on target with a 16 per cent return over the few days they traded in February and the progress has continued through March, although they have yet to declare their figures.
"We don't trade through times of uncertainty," said Dr Shepherd. Of the typical 20 trading days a month, "eight are nice", and it is on these few days that the model can deliver its advantage.
Interestingly, the model can be tailored to suit different trading styles and whether the trader wants to hold a position for hours or for a few days. "If you feed it [FTSE data] in once a day it will predict a day or two in advance. If you put it in every five minutes it will give you two to three hours."
The company is treading warily so that it does not run foul of the regulatory authorities, Mr Loginov said. It is relatively new territory even though much of what it is doing is controlled under FSA guidelines for investment club activity.
The company is now assembling Club 4 with outside investors, although it has not begun buying futures yet. A club would typically hold about 20 people and UK law says that the club must make its own decisions and cannot be guided by Investment Alchemy, said Mr Loginov. Club members will be entitled to use Dr Shepherd's software, however, in as conservative or aggressive a trading style as they like.
The company expects to set up about 100 clubs in this way and will gain returns by servicing the clubs and the shared software. It also has plans to offer a "home trader" service for individuals who want to trade for themselves outside a club, and for the creation of an offshore investment fund, with the company operating inside the UK as the fund manager.
The Republic and Guernsey have both been considered as locations for an offshore fund, Mr Loginov said, and the IFSC would be the target here.
The structure of the fund would have to be on the basis of compliance with local regulations but also the FSA's systems. Ultimately fund management would be expected to net the greatest returns for the company, he added.
Investment Alchemy is in its infancy but there is no shortage of interest given the planned return on capital. On March 18th it ran an explanatory seminar for investors at the Raddison Edwardian at Heathrow, Dr Shepherd said. The 50 participants were each charged £1,000 for the day and at the close of business most were willing to join the next club.
"We actually could have taken £2.5 million (€4 million) under management on that day" had they been in a position to do so, Dr Shepherd said.
