HOLY GRAIL, IS THERE ONE?

One comment made yesterday got me to thinking that I have never really reviewed the different approaches to trading that one can take. Today I will do a brief overview of different ways of trading/investing and their virtues and drawbacks. I will take one of the below approaches each day and discuss them.

Here is an equity curve of an SP 500 Mechanical trading system I have used in the past. You can see the huge gains, then the leveling off in recent years. What this represents is typical. A mechanical system which identified short term imbalances and sought to take advantage of them. It worked very well for awhile, then all of the sudden it's equity curve is going sideways. This is typical of so many different approaches that are mechanical, and the main reason why I do not trade with them anymore.

Here are the different ways you can trade/invest:

Systematic Trading

Discretionary Trading

Arbitrage

Buy and Hold

Macro-economic Top Down

SYSTEMATIC TRADING

With this approach you craft a fixed set of rules for entries and exits and follow them without question or hesitation. This is a very effective way of taking emotion out of trading. The very best in this category can make 20 - 30% per year pretty regularly. There are years where the systems work exceptionally well and you do much better than that. I used to trade that way and did experience a few very good years well beyond this level of return. The challenge with this is twofold.

First you have to develop a good set of rules with edges in the markets. This is not easy. Over optimizing past data is a chronic problem and often leads to subpar out of sample performance.You have to have something to base your systems on, so researching what has occurred in the past is the best way to try and develop rules for buying and selling. I have spent many years backtesting various ideas for exploiting what I see as edges in the markets. I have often found significant results to some of my ideas. At one point after studying just daily seasonal tendencies for up and down closes in both Bonds and SP 500, I developed a system to trade that bias. Any bias over 85% I entered the market at the opening the next day and exited on the first profitable opening. I ran off 55 consecutive winning trades with that. To this day that is by far the best such run I have ever had.

This was a case where the actual trading far outperformed the back testing. Outcomes like this rarely happen, but occasionally you get lucky. However, I started to run into trouble with this approach, took a few losses, then realized this was a dumb way to trade and shelved it. That wound up being the greatest call I have ever made, because that system has not made a yearly profit since that time. I would have lost alot of what I made had I continued on with it. Ironically a judgement call outfperformed the mechanical here in the end. However, in defense of systematic trading, alot of that money made from that is still in my bank accounts so it was not a total loss.

Second, the single biggest drawback to this approach, ultimately almost every system I have ever developed at some point stopped working. They all became losing systems some after years of profits. There are a few reasons for this. First and foremost, there are a ton of smart people on wall street. Some of these firms hire one brain child after another out of MIT to develop systematic approaches to exploit market ineffeciencies. As a result, as individual traders we have very strong competition here on the idea front. We may discover something, but at some point these powerhouses also discover it. Once that happens, it gets "arbed" out. This means the edge is eliminated and no longer can be traded profitably.

You can certainly chase your tail on these types of things and as long as you can stay ahead of the game and accept that a good system will last a year or two at most, then this is still a good approach to use. You will have the pressure of having to constantly stay ahead of the curve here, developing new ideas over and over. It is unlikely you can develop an approach, then make a 10 year plan to use it. It will just not be effective for that long.

Being a martial arts guy and ex wrestler, I am one of the most disciplined people any reader of this blog would ever meet. This approach suited my personality very well due to this. I could follow the rules without question. Many or even most people, cannot do this. You have to understand that if you literally miss one trade, or do one incorrectly, or pass on one, etc.., you can ruin your whole year with this approach. That one trade you miss could be the single biggest trade of the year. When I had my trading service, we had a 5 month stretch without one single loss trading Bonds. This was an incredible run, 22 straight wins. It was completely mechanical, just log in to my site, get the orders for the trades, and click the mouse. I actually had a client at the time who cancelled his subscription because he had lost money! How the hell could anyone have lost money during a stretch without one single losing trade?

He was such a pin head that I never went far enough to determine how that could have happened, but obviously he did not follow the rules. Very few people can do this correctly. This person was typical of why this approach does not suit everyone. You have to match your approach to your personality or you will not succeed.

I will discuss Discretionar Trading tommorrow.

Good trading to all of you