Tweaking Your System

System trading has many benefits, but once a trader chooses his approach, there will come a time when he will have to make a decision to update his system to adapt to the ever-changing market conditions. The economic climate changes, based on cycles. Governments raise and lower interest rates to meet their financial goals for their economies. Government leaders come and go, each with a slightly different style of implementing their policies. This affects business cycles that economies go through--a little differently each time. With all these variables, it is inevitable that economic cycles tend to behave a little differently from each other, even though they all basically go throughout the same periods of expansion and contraction. System traders need to be aware of these longer-term phenomena if they are to prosper on a long-term basis. The purpose of this article is explore this problem and offer some possible solutions.

Today’s economic climate

Today’s economic climate is vastly different from that of 20 years ago. One only has to look at interest rates then and now. The volatility in rates in the 1980s was significantly higher than it is now. Governments were trying to control economies that had more supply-and-demand disruptions that happened with much more instability than is common in today’s economy. The primary reasons for this vast difference is globalization and technology. With the great progress in technology, economies and the people who make policy for them, have gotten much better at managing supply-and-demand pressures and have been able to smooth out the bumps that occur in the business cycles. A consequence of this has been an increase in globalization, meaning increased capital and resources traveling throughout the world where it is most needed. A good example of this is how the Internet has made economies more efficient and stable.

The Internet has made information more accessible to buyers and sellers on a level never seen before. This has increased the flow of goods and services by making it very easy for the consumer to satisfy his needs. As a result, the disruptions in the supply/demand chain have been smoothed out and have reduced the need for policy makers to change their interest-rate policies to try to control their economies. With lower interest rates and less frequent interest-rate changes, economic expansions have been able to last longer and go farther than before, with a less "boom bust" characteristic.

Who does all this relate to a systems trader?

If we examine the returns in a typical trend-following system, we can see that the returns were much more attractive back in the higher interest rate environment than today. Why would this be? It is because with more supply/demand disruptions in the economy, there are more drastic changes in prices, which create better trading opportunities for most systems. This is compared to the climate of today which is characterized by these disruptions getting satisfied much more quickly and smoothly by means of a higher level of technological advancement. For example, if we look at the bond market back in the 1970s, we can see that large price moves were much more frequent and larger than today. Why is this? Most likely because the U.S. government had to apply the brakes (raise rates) and step on the gas pedal (decrease rates) in a much more unstable manner. This was probably caused because the economy was much more unstable than before, because of the increased difficulty of satisfying supply demand pressures. 

Let us examine Table 1, which shows the yearly profit and loss of trading a simple channel breakout system. The system buys when the market closes at a 40-day high and exits its position when the market closes at a 20-day low. Vice versa for short trades. This system needs large price disruptions to make money because when it goes long, prices have already made 40-day highs and it needs prices to go even higher. This is usually the case however when you have an economy that is relatively more unstable than the one in the early 1980s. If we examine the Table, we can see that the majority of gains were made in the early to mid 1980s with 1980, 1984, and 1985 being particularly good. This period of time was coincidental with the U.S. economy coming out of a recession and the government starting to lower interest rates. If we examine the Table again, we can clearly see that profitably has been declining and the rate of profitability has also been declining. Furthermore, the system has not had a money-making year since 1996. This is probably because of the prosperity that the U.S. economy has enjoyed and one of the longest economic expansions on record. As a result, interest rates have been low and there has not been a lot of volatility in them as well. Consequently, this system has not had a favorable environment lately.

Annual Trading Summary