Systematic Trading

Key Takeaways

1. Systematic trading overcomes human biases and emotions

"Creating a trading system removes the emotion and makes it easier to commit to a consistent strategy."

Cognitive biases hinder performance. Humans are prone to numerous cognitive biases that can negatively impact trading decisions. These include:

• Overconfidence: Believing we're better at predicting markets than we actually are
• Loss aversion: Holding onto losing positions too long and selling winners too early
• Recency bias: Giving too much weight to recent events or data

Systematic approach provides discipline. By implementing a rules-based trading system, investors can:

• Remove emotional decision-making from the process
• Consistently apply proven strategies across various market conditions
• Avoid impulsive trades based on fear, greed, or temporary market noise

Backtest and validate strategies. Systematic trading allows for thorough backtesting of strategies, helping investors:

• Understand how a strategy would have performed historically
• Identify potential weaknesses or risks in the approach
• Gain confidence in the system's ability to weather different market environments

2. Simple trading rules often outperform complex strategies

"I am not a fan of complex fitting methods and I prefer not to use them."

Simplicity promotes robustness. Simple trading rules tend to be more robust and less prone to overfitting than complex strategies. Benefits include:

• Easier to understand and implement
• Less likely to break down in changing market conditions
• More likely to capture persistent market inefficiencies

Examples of effective simple rules:

• Trend following: Buy assets with positive momentum, sell those with negative momentum
• Mean reversion: Buy assets that have fallen significantly, sell those that have risen sharply
• Carry: Profit from yield differentials between assets

Avoid over-optimization. Complex strategies with many parameters are often over-optimized to past data, leading to poor future performance. Instead:

• Focus on well-established, theoretically sound principles
• Use a limited number of parameters in your trading rules
• Prioritize out-of-sample testing to validate strategy performance

3. Diversification is crucial for managing risk and improving returns

"Diversification really is the only free lunch in investment."

Benefits of diversification:

• Reduces overall portfolio risk
• Improves risk-adjusted returns
• Smooths out performance across different market conditions

Diversify across multiple dimensions:

• Asset classes: Equities, bonds, commodities, currencies
• Geographies: Developed markets, emerging markets
• Sectors: Technology, healthcare, finance, energy, etc.
• Trading styles: Trend following, mean reversion, carry, value

Correlation is key. Focus on combining assets and strategies with low or negative correlations to maximize diversification benefits. Tools for measuring and optimizing diversification include:

• Correlation matrices
• Principal component analysis
• Risk parity approaches

4. Avoid overfitting by using ideas-first approach and limited data

"I prefer to come up with a relatively small number of ideas for trading rules."

Ideas-first approach. Start with a sound theoretical basis for your trading strategies, rather than mining data for patterns. This method:

• Reduces the risk of finding spurious relationships in historical data
• Focuses on persistent, explainable market phenomena
• Improves the likelihood of future strategy success

Limit data used in strategy development:

• Use a subset of available data for initial strategy development
• Reserve a significant portion of data for out-of-sample testing
• Implement expanding window or walk-forward optimization techniques

Be wary of data mining pitfalls:

• Avoid testing an excessive number of parameters or variations
• Be skeptical of strategies with unusually high historical performance
• Consider the theoretical basis and economic rationale behind each strategy

5. Position sizing and risk management are critical for long-term success

"Deciding your overall trading risk is the most important decision you will have to make when designing your trading system."

Volatility targeting. Use a consistent approach to position sizing based on the volatility of each asset:

• Set a target portfolio volatility (e.g., 10% annualized)
• Adjust position sizes to maintain consistent risk exposure across assets
• Regularly update volatility estimates to adapt to changing market conditions

Risk management techniques:

• Stop-losses: Automatically exit positions that move against you by a predetermined amount
• Position limits: Cap the maximum exposure to any single asset or strategy
• Correlation-based sizing: Reduce position sizes for highly correlated assets

Kelly criterion and half-Kelly. The Kelly criterion provides a mathematical framework for optimal bet sizing, but in practice:

• Use a more conservative "half-Kelly" approach to account for estimation errors
• Adjust overall risk based on your personal risk tolerance and financial situation

6. Trading costs can significantly impact performance

"To avoid this scenario it's better to start with significantly lower trading capital and gradually increase it until you have the full amount invested."

Types of trading costs:

• Commissions: Fees paid to brokers for executing trades
• Spreads: Difference between bid and ask prices
• Slippage: Price movement between trade decision and execution
• Market impact: Price changes caused by your own trading activity

Strategies to minimize costs:

• Trade less frequently: Implement longer-term strategies when possible
• Use limit orders: Aim to capture the spread rather than crossing it
• Choose liquid instruments: Focus on assets with tight bid-ask spreads
• Optimize execution: Use algorithmic trading to minimize market impact

Cost-adjusted performance evaluation:

• Always consider trading costs when backtesting strategies
• Set realistic cost assumptions based on your trading size and frequency
• Monitor actual trading costs and adjust strategies if necessary

7. Combine multiple trading rules for robust performance

"I think that a balanced combination of trading rules, with different styles that work in different environments, is better than any single alternative."

Benefits of multi-strategy approaches:

• Improved diversification across different market regimes
• Reduced reliance on any single strategy or market inefficiency
• More consistent overall performance

Combining strategies effectively:

• Use strategies with low correlations to each other
• Allocate capital based on risk-adjusted performance and diversification benefits
• Implement a systematic approach to weighting and rebalancing strategies

Example strategy combinations:

• Trend following + mean reversion
• Momentum + value
• Carry + volatility strategies

8. Regularly rebalance and adjust your portfolio

"You should also reduce your trading capital, and hence your cash volatility target, if you withdraw money from your trading account or investors redeem."

Importance of rebalancing:

• Maintains target risk levels across assets and strategies
• Captures profits from outperforming assets
• Ensures diversification benefits are preserved over time

Rebalancing approaches:

• Time-based: Rebalance at fixed intervals (e.g., monthly, quarterly)
• Threshold-based: Rebalance when allocations deviate beyond a certain percentage
• Volatility-based: Adjust positions based on changes in asset volatility

Adapting to changing market conditions:

• Regularly review and update volatility estimates
• Adjust overall risk exposure based on market regime indicators
• Consider incorporating dynamic asset allocation strategies

9. Be realistic about expected returns and drawdowns

"Assume your trading will go badly, be prepared for that eventuality, and be pleasantly surprised if it doesn't."

Setting realistic expectations:

• Historical Sharpe ratios for diversified portfolios typically range from 0.5 to 1.0
• Expect significant drawdowns, even with well-designed systems
• Understand that past performance does not guarantee future results

Preparing for drawdowns:

• Use conservative position sizing to avoid blowing up during tough periods
• Maintain sufficient cash reserves to weather extended drawdowns
• Psychologically prepare yourself (and your investors) for periods of underperformance

Continuous improvement:

• Regularly review and analyze system performance
• Identify areas for potential improvement without overfitting
• Stay informed about new research and market developments

Last updated: February 4, 2025

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