Trading Places
Dan Akroyd and Eddie Murphy, as they prepare to enter the trading pits:
Louis Winthorpe III: Think big, think positive, never show any sign of
weakness. Buy low, sell high. Fear? That's the other guy's problem. Nothing you
have ever experienced will prepare you for the unlimited carnage you are about
to witness. Superbowl, World Series - they don't know what pressure is. In this
building, it's either kill or be killed. You make no friends in the pits and you
take no prisoners. One moment you're up half a mil in soybeans and the next,
boom, your kids don't go to college and they've repossessed your Bentley. Are
you with me?
Billy Ray Valentine: Yeah, we got to kill the mother f****r - we got to
kill 'em!
--from "Trading Places"
Just as Randolph and Mortimer Duke explored the endless debate of environment
versus heredity in the movie Trading Places, over the next two weeks we'll dive
into the debate of systematic trading versus discretionary trading.
The Debate
Systematic trading has been around for decades. Yet, up until a few years ago,
it was viewed suspiciously by most of Wall Street. The overwhelming feeling was
that no system could ever do better than a team of well-trained individuals who,
with proper risk controls, could find the best opportunities to trade each day.
But, over the past few years, there has been a concentrated movement by many
firms to hire "quants" who rely upon statistics to help make trading decisions.
Many of these quants graduate from top schools (we have one on our staff...MIT) and many have advanced degrees in physics, mathematics and computer
science. Many of the firms who rely upon a systematic way to trade will tell you
that it's the only way to go. On the other side of the coin, there are many,
many firms (and many great traders) who will tell you that they've always made their money using
discretion and they will always trade this way. So, who's right?
Let's Look For The Answer...
I suspect that this question has entered your mind as it pertains to your own
trading. Should you trade systematically, or are you better off using your
own experience and intuition? Before we get to the answer, let's look at the
pros and cons of each. This week, we'll look at systematic trading
and next week we'll look at discretionary trading. And from there, you'll be able to
make educated decisions for your own trading
Systematic Trading
First, I'll tell you that over the past few years I've slowly but surely evolved into a systematic trader. But,
as you will see, I'm going to be brutally honest about the strengths and
weaknesses of each approach.
Let's define what systematic trading is. It's trading with an exact set of rules.
These rules are so tight, that a 15-year-old can execute the trades for you.
When the system says "buy," you buy. When it says "sell," you sell. No questions asked.
No discretion ever taken...period!
Let's begin with the negative side. First and foremost is:
how well tested is the system? Questions must immediately arise as to how far the look- back
period was for the testing. Does the look-back period include both bull and bear
markets? Does it go back at least 7-15 years, or is the period much shorter?
Were the returns of the system distributed equally over the period tested, or
did they mostly occur in one or two years? How many rules does the system have?
(the more, the worse. I've seen systems that have pages of code...uugghh!!!)
The list can go on and on and many systems fails because they are deficient in
one way or another.
In my opinion, the best systems have many years
of data and are combined with few rules (your motto should be "a few rules are
good -- fewer better."). And these rules must make market sense. Maybe someone
can show a system that has been correct 100% of the time when buying the S&Ps the day following a game that Roger Clemens pitched and won.
Wouldn't that be great? 100%
correct! It has hypothetically never been wrong in a decade. One rule. More than 15
years of data. But it makes absolutely no sense. It's just like the Super Bowl
System...it's nonsense, yet it gets quoted every year by the geniuses in the
financial media. So, the biggest detriment to trading any system is whether or
not it's valid and whether its rules have integrity.
Now, let's assume it is a valid system and all the above stipulations have been met. The next
question becomes: what happens if the system stops working? Worse, how do you
even know it has stopped working? It may have 4, 5 or even 10 losses in a
row. But, for many, many good systems, this will happen from time to time. At
what level of losses does it make sense to drop the system? It's a very, very
tough question, and one that is dealt with all the time by systematic traders.
Let me give you an example. There is a very well known trend-following system
used by many money managers (CTA's), including the original Turtles group. The
system basically trades a basket of commodities (rarely stocks) and uses a
20-day high to enter and a 7-day low to exit (shorts use a 20-day low and a
7-day high as the exit). From there, it goes deeper as money management,
pyramiding, and portfolio management take over. Some of the biggest names in the
business use variations of this method, including John Henry, the owner
of the Boston Red Sox. Henry has had two decades of success systematically
trading his money and others' money with this approach. So much success that he
can afford to own a baseball team. But, look at his funds' track record this
year. Through July 31, six of his funds are down more than 20%. Two
are down over 30%! His biggest fund is down over 24% over the past 12 months
(this data can be found at www.iasg.com). Not
only does he run the risk of owning a baseball team which won't make the
playoffs, along with facing the prospect that the hated Yankees may field a team
next year that includes Nomar Garciapara at 2nd and Pedro Martinez on the mound
(yes, Steinbrenner is that sadistic), but he also has massive drawdowns
occurring in his funds using a system that has worked for many, many years.
Does this system no longer work? I suspect it still does work, but these drawdowns
are amongst the biggest he has seen. And, many other big name money mangers with
long, successful long-term track records using this approach are seeing losses of the same
magnitude (see Dunn Capital as another example). And, as with any system, no one will know if this
methodology is dead until after it's dead. And by then, it's obviously
many years too late.
So the question that Henry, Dunn and the other trend followers now face (and
have faced in the past) is: does their system still work? Do they change
to a new system or do they continue using their current system? Millions and
potentially hundreds of millions of dollars of fees are at stake. And, even
though I have no idea what they are thinking, it must be very painful to live
through these losses. And these people face business decisions that are
critically important to their business' long-term success.
The next thing to consider when deciding to trade the system is: do you have
the intestinal fortitude to sustain the drawdowns and losses that every system has
and not jump to a new system? The human urge is to walk away
from a system with a few losses and move into a system that has had recent gains. But,
many times, the best time to trade a valid system is after it has had
losses. And the worst time to start trading a system is after it's had many
winning trades. Few people can do this. They
leave the system after its had a handful of losses, or worse, they start trading
more aggressively AFTER the system had a string of winning
trades. This usually occurs right before the law of averages kicks in and some
losing trades occur.
Going further, what about tweaking the system?
This means making small changes along the way even though the system has
historically been a winning one. That's another urge that most traders have to
deal with, especially during drawdowns.
Another pitfall of systematic trading is that it's boring. There's little
intellectual stimulation from it. All the thinking has already been done and
placed into the system. And for many people, part of the love of trading is not
only making money, it's also the challenge. And there is little challenge
when your only job is to execute trades when a signal triggers.
I've listed only a few potential pitfalls to systematic trading, and there are
many more. But -- as you will learn next week -- there are just as many
drawbacks when it comes to discretionary trading.
Five Benefits Of
Systematic Trading
1. If the back-testing for the system is solid, not optimized and done
correctly, one has the peace of mind of knowing that the setups being used have
made money in the past. And even though there is no assurance they'll continue
to perform in the future, should the system perform in-line as it has for many
years past, the user of the methodology is likely to be very, very pleased over
time.
2. It is quantifiable. It is impossible to quantify discretionary trading. Different people looking
at the exact same thing will nearly always interpret what they see differently.
Systematic trading has no fuzzy rules- it's always black and white. At all times
you have clarity
3. Systematic trading takes much of the gut wrenching, up and down emotion out
of trading. There's nothing to think about during the day. You simply take the
signals. If you don't, you're not only a discretionary trader, you're bringing
the chaos back in which always leads to the emotional roller coaster most
discretionary traders experience.
4. Further to number three. The noise created by the media and Wall Street
analysts is eliminated. Their "un-quantified guessing" officially becomes
irrelevant. All of us are swayed one way or another in our thinking by these
people. But, not the system. The system has no mind. It simply triggers the
signal and the trade is taken.
5. If the system continues to work, you're freed up to do other things. You can
spend time enjoying other things in life (like watching Trading Places
for the 943rd time) and/or you can even spend time
thinking of additional ways to make money. You don't have to be glued to the
screen all day. For some people, this doesn't matter. For many others, it's a
big plus.
No guessing, little emotion, and more free time are the benefits of systematic
trading. And the biggest benefit is that if the system continues to perform,
you'll very likely make good money for quite some time.
Next week we'll look at the pros and cons of discretionary trading. And from
there, we'll put the entire picture together to help you decide what's the best
route for you to take.
Have a great week trading (and if you have any questions or comments, please
email them to me at
lconnors@tradingmarkets.com)!
Larry Connors
