The Biggest Myths In Systematic Trading
Debunking Some Of The Most Common Misconceptions
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Introduction:
The terms “Systematic Trading”, or “Algo Trading”, or really any term meaning trading with computer models have a certain connotations/assumptions associated with them. Some people think systematic trading makes money consistently, or removes human emotions, or requires high knowledge of math/science etc. There are all kinds of myths and assumptions people jump to when they hear about systematic trading. Most of these assumptions are wrong. In reality, systematic trading for retail traders is actually a lot different than what many people may think. In this article, we are going to walk through a list of myths commonly associated with systematic trading. Hopefully by the end of this article you will have a better understanding of what systematic trading is and what it is not.
Myth 1: Systematic Trading Is Set And Forget
A lot of people think that once they have a trading system, they can automate it and never touch it again. They assume it’s just a passive income source that runs forever in the background. This is most certainly not the case. Trading systems can crash, your power can go out, your network can go out, there could be a bug in the code etc. There are so many things that could cause an automated trading strategy to crash or go haywire. An automated trading strategy needs constant monitoring and performance reviews. You need to ensure the strategy is behaving within expectation and that live trading is matching the backtested performance. If you automate your trading strategy and leave it untouched or monitored for long periods of time, you’ll likely find your performance results don’t meet your expectations due to the reasons listed above.
Myth 2: Systematic Trading Makes Money Consistently
Another common myth is people think that once they automate a strategy they should expect consistent profits every day. This is not the case. I have never heard of a trading strategy that makes money every single day. In fact, many times there are weeks, months, or even years where a systematic trading strategy doesn’t make money. You need to be prepared for this because if you’re expecting to trade to replace the income from your day job, if the trading system doesn’t make money for long periods of time that could be a difficult situation. There is no guarantee of profits from day to day, in fact some days/weeks/months/years the trading system will lose money! Imagine going to your day job and your boss takes money from your pockets instead of giving you a pay check for the week. That’s how trading works sometimes. Lower your expectations and be ready for the times where the trading system doesn’t make any money, or even loses money.
Myth 3: Systematic Trading Is A Way To Get Rich Quick
If systematic trading was a get rich quick scheme, then everyone would be doing it. Systematic trading is hard and requires a lot of work and time commitment. Not the attributes I would associate with “get rich quick”. It takes years of compounding growth from your systematic trading to actually make a decent amount of money. If you’ve heard stories of people getting rich fast from trading, it’s due two potential reasons. The first reason is because these people are lying and are actually trying to sell you something; their money came from the sales of a trading related product rather than the trading itself. The second is because these people used ridiculous amounts of leverage or took on crazy amounts of risk and got lucky. You only hear the success stories when this happens, you never hear about the people who risked it all to make it big and lost everything. Unless you’re a gambler and want to risk it all to become rich, systematic trading is a marathon. It takes time to build wealth, patience pays and anyone saying otherwise is lying or doesn’t know what they are talking about.
Myth 4: Systematic Trading Requires Advanced Degrees In Science And Math To Be Successful
Systematic trading systems can be as simple or complex are you want. You could create a system with complex mathematics, or a system built around 8th grade level algebra. Most of my trading systems don’t use math any more complex than averages, percentages, summation, and ranking. There is no need to use complex math if you don’t want to. Simple systems work, are robust, and are less likely to be overfit to the data. Don’t think that just because you are not super adept in mathematics that you can’t create systematic trading strategies. Also, on the flip side, if you are very well versed in mathematics or science don’t think you can make an advanced trading strategy and dominate the markets from the beginning. The real take away is everything takes time, experience, and a willingness to learn. Just because you are super smart doesn’t necessarily directly translate to systematic trading. Both simple and complex stuff can work and you can be successful with either once you understand the proper methodologies of systematic trading.
Myth 5: Systematic Trading Models Are A Black Box
While some traders do create black box trading systems, most retail systematic traders I know do not. A black box trading system is one where the calculation to determine a buy or sell signal is a non-linear calculation and there is a lack of understanding as to why the trading signal was generated. Honestly, this is undesired compared to a full understanding of every part of your trading system. Understanding your trading system is critical because you need to know when and why your trading system makes money. If your trading system should be making money in a bull market and it’s not, then you know something is very wrong. Understanding your system helps you figure out if anything unusual is going on. If you have a black box and your trading system starts losing money, you don’t know if that’s normal or if the system is actually broken.
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Myth 6: Systematic Trading Removes Human Emotions
This is a common myth. Discretionary trading comes with many emotions, so it may seen intuitive that automating and systematizing the whole process so a computer makes the buy and sell decisions would remove emotions. This, in fact, is not the case. When a computer is automatically placing buy and sell orders, it is tempting to try and override your trading system when it tries to take trades your emotional mind doesn’t agree with. When your trading system is in a drawdown it is tempting to turn the system off to prevent any more losses. Remember, whether you trade discretionarily or systematically, the money in the trading account is still yours and you will have an emotional reaction to any fluctuations. I’ve been trading systematically for years and I still feel emotional urges to override systems or turn them off. Emotions don’t just disappear because a computer is making the buys and sells instead of you.
Myth 7: A Backtest Proves a Systems Profitability
A backtest does nothing more than show how a certain combination of rules, which make up a trading system, performed historically. There is no proof that the system will continue to make money in the future. In fact, there is nothing we can do to prove a system will continue to be profitable in the future. There are certain techniques we can use to convince ourselves that continued future performance may be probable, but there is never proof. It’s very easy to curve fit a backtest, where the system is fitted to random noise in the historical data which will not repeat in the future because, well, it’s random noise. So remember, a backtest is for understanding how a trading system has performed, not how it will perform in the future.
Myth 8: You Just Need One Amazing Trading Strategy (The Holy Grail)
The search for the holy grail will never end for some people. The holy grail is a magical make believe trading strategy that has amazing performance, makes money every day, and has virtually no drawdown. This trading strategy does not exist, anyone trying to sell you a trading strategy like this is lying. There is no one amazing trading strategy. Most trading strategies are just okay. Having just one okay trading strategy may not be that exciting, but this is why you want to have many okay strategies. If you simultaneously trade many trading strategies that make money and lose money at different times, then the combined performance will be greater than the sum of the parts. The only holy grail in trading is a suite of many uncorrelated trading strategies all working together in a portfolio. So stop spending so much time trying to make your one trading strategy perfect, you’re likely just curve fitting. Instead be okay with strategies that are just okay. Create many of these okay strategies and you’ll be surprised by the combined performance.
Myth 9: Systematic Trading Is Gambling
Trading and gambling often get compared. Gambling is when you bet something is going to happen and you have no insight on what the outcome will be or probability of outcomes could be. This can defiantly happen in the stock market, blindly buying and selling stocks on a random bet you have on a company. Where proper systematic trading is different is these bets are educated based on data. A well developed systematic trading strategy seeks to exploit some effect in the market which is repeatable and statistically significant. These are educated bets with a positive expectancy. Not all bets will be profitable, but given enough time the system should make money. If you hand a systematic trader and a gambler $10,000 and then gave them 3-5 years to turn it into as much money as possible, the systematic trader would come back with double the money and the gambler would be in debit. The difference is gambling is based on randomness, systematic trading is based on exploiting repeatable anomalies.
Myth 10: High Frequency Trading Is The Best Way To Trade Systematically
Some think that creating a trading system that buys and sells extremely quickly is the best or only way to trade systematically. Jumping in and out of positions in a matter of seconds or minutes sounds cool, but really it’s a great way to lose money as a retail trader. We all have to have to pay commissions on trades, the money a high frequency trading system will generate will likely not overcome the cost of commissions. Yes, there are commission-free brokers out there, but these brokers sell your trade data to large firms that can front run your orders, inducing slippage, which again will eat away your profits from a high frequency trading system. Also, high frequency trading is a realm that large hedge funds play in. They are your competition on this short timeframe. Us retail traders do not have the access to same data or intricate infrastructure like large hedge funds do. To hedge funds, it’s like taking candy from a baby when retail traders attempt high frequency trading. Instead, focus on trading timeframes of a few hours to a few years. I trade many timeframes where I may hold a position for just 1 day, or timeframes where I may hold a stock for years if it keeps climbing up. I don’t do any trading quicker than that. So please don’t do any high frequency trading, unless you want large hedge funds to take all your money.
Conclusion:
Hopefully this short article has cleared up some of the misconceptions around systematic trading. Most people don’t understand systematic trading, it is like voodoo to those who have never explored it. Writing computer code to trade stocks for you? You can’t blame them for thinking it’s crazy because it sounds insane! It is possible though, you just have to work hard and not give up and you can succeed.
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