Recovering From A Bad Algo Trade (Or A Drawdown)
We’ve all heard the saying “you can’t teach an old dog new tricks.” While this might hold true for many professions – quite a few tax accountants probably take early retirement every year, rather than deal with ever changing and complicated government tax laws – good traders can’t act like old dogs.
Think about traders and investors who were “buy and hold” diehards before the financial crisis. Were they able to sustain through the immense price drops, shown in figure 1, or did they adapt and find new tricks – new ways to generate returns from the markets? In a similar way, many followers of the “turtle” trading method, based on Donchian breakouts, have found the going tough these past few years, and have had to adapt their trading accordingly.
Think about traders and investors who were “buy and hold” diehards before the financial crisis. Were they able to sustain through the immense price drops, shown in figure 1, or did they adapt and find new tricks – new ways to generate returns from the markets? In a similar way, many followers of the “turtle” trading method, based on Donchian breakouts, have found the going tough these past few years, and have had to adapt their trading accordingly.
No matter how good a trading strategy is, it is naïve to think it will last forever. The best traders are constantly researching, developing new strategies and adapting their methods to survive and thrive in an ever changing marketplace. This constant adaptation can take many forms: changing of styles, changing of markets traded and changing of strategies employed, for example. Some change their strategy building approach to improve. The best traders learn to use all these tools in an effort to stay ahead of the game.
Changing Styles
The most profound way a trader can change is in the style of trading. When pressed, we all identify ourselves as a certain type of trader. “I am options seller” says one person. “I’m a day trading discretionary trader” says another. Almost everyone identifies with one primary method, and pursues that as their passion. By doing so, are they unknowingly pigeonholing their trading?
Suppose, instead, that traders only identified themselves as “I’m an alpha generating trader.” That would open the doors for the trader to pursue any and all possible methods of trading, as long as the method generated excess return. Is this a good idea?
(By the way, if you want to know if your strategy has alpha - positive expectancy - head over to my Calculator page and look for the Expectancy calculator.)
The answer, of course, is “it depends.” For example, in 2015 many options traders (likely premium sellers) reported excellent returns, while many trend following futures traders have been struggled to keep pace. But in years past, the exact opposite was true. And in the future, who knows what will work best?
So, having many different styles at a trader’s disposal is a valuable asset. If a trader allocated a certain amount to option selling, trend following and day trading, for example, he might be able to generate good returns regardless of which method performed the best in any given period of time. Or, if he was really sharp, instead of trading all three methods simultaneously, he could switch from method to method as the market favored one approach over another.
Certainly, there are drawbacks to such a multipronged approach. First, it is easy to become a “jack of all trades, master of none.” It is reasonable to assume that someone trading disparate methods could not become an expert in all of them, and would therefore not be trading optimally. Results would suffer compared to traders who specialized.
Another problem would be with the trader that switched from style to style, depending on what was “hot.” Such a trader would probably switch too late to a new method, and stay too long before switching to the next method. In this way, the trader would always be one step behind, and his results would reflect that.
While changing styles of trading, or trading multiple styles at the same time, could work, there might be better methods of adapting to changing markets. One possibility is to change the markets themselves.
Changing Markets
Ask any Euro currency trader what 2014 was like, and they’d probably respond “awful.” As shown in Figure 2, the volatility on the Euro reached historic lows in 2014. While this might have been good for some options strategies, for most futures trend traders, the prospects were minimal. Simply put, if the market price does not move, there is little opportunity for profit.
Changing Styles
The most profound way a trader can change is in the style of trading. When pressed, we all identify ourselves as a certain type of trader. “I am options seller” says one person. “I’m a day trading discretionary trader” says another. Almost everyone identifies with one primary method, and pursues that as their passion. By doing so, are they unknowingly pigeonholing their trading?
Suppose, instead, that traders only identified themselves as “I’m an alpha generating trader.” That would open the doors for the trader to pursue any and all possible methods of trading, as long as the method generated excess return. Is this a good idea?
(By the way, if you want to know if your strategy has alpha - positive expectancy - head over to my Calculator page and look for the Expectancy calculator.)
The answer, of course, is “it depends.” For example, in 2015 many options traders (likely premium sellers) reported excellent returns, while many trend following futures traders have been struggled to keep pace. But in years past, the exact opposite was true. And in the future, who knows what will work best?
So, having many different styles at a trader’s disposal is a valuable asset. If a trader allocated a certain amount to option selling, trend following and day trading, for example, he might be able to generate good returns regardless of which method performed the best in any given period of time. Or, if he was really sharp, instead of trading all three methods simultaneously, he could switch from method to method as the market favored one approach over another.
Certainly, there are drawbacks to such a multipronged approach. First, it is easy to become a “jack of all trades, master of none.” It is reasonable to assume that someone trading disparate methods could not become an expert in all of them, and would therefore not be trading optimally. Results would suffer compared to traders who specialized.
Another problem would be with the trader that switched from style to style, depending on what was “hot.” Such a trader would probably switch too late to a new method, and stay too long before switching to the next method. In this way, the trader would always be one step behind, and his results would reflect that.
While changing styles of trading, or trading multiple styles at the same time, could work, there might be better methods of adapting to changing markets. One possibility is to change the markets themselves.
Changing Markets
Ask any Euro currency trader what 2014 was like, and they’d probably respond “awful.” As shown in Figure 2, the volatility on the Euro reached historic lows in 2014. While this might have been good for some options strategies, for most futures trend traders, the prospects were minimal. Simply put, if the market price does not move, there is little opportunity for profit.
The obvious way to handle a “dead” market is to simply change markets. The key to this is having a portable method, one that works with multiple markets. A price action trader, for example, could abandon the Euro, and use the same general principles of price action to trade crude oil.
It sounds simple, but the trader will likely spend a lot of time figuring out the nuances of the new market, and likely lose money during this transition period. Taking for granted that a general trading methodology will work for all markets can be a dangerous assumption.
Obviously, many strategies or techniques that work in one market will probably not work in another market. A currency trading program, for example, likely relies on exploiting long term trends. Such an approach would likely not fare as well with stock market indices, which tend to be more mean reverting, with a long term upward bias.
Therefore, while trading a new market may be desirable, it might only be possible with the third radical change a trader can make: trading new and different strategies.
Changing Strategies
A third way to “teach an old dog new tricks” is to plan for strategy obsolescence upfront, and build an approach that embraces it. What does this mean? Simply put, the trader creates multiple strategies and makes the assumption that each strategy will eventually stop working.
It may not happen for one year, five years or fifty years, but assuming a strategy will eventually be ineffective, and planning accordingly (by using appropriate risk management) is a much better alternative to assuming a strategy will work for eternity.
How is this accomplished? Traders who embrace this approach will continually build new strategies. The strategies will be different styles, different timeframes and different markets. The key is that each strategy by itself must be properly developed and tested, and must demonstrate a long term positive expectancy.
One can think of it as the R&D function of a company. New strategies, like new products or services, are continuously created and then moved on to production. The process ends only when the trader decides to give up trading.
Building and trading multiple strategies, in addition to keeping the trader’s approach fresh with the current market, also has an overlooked, but tremendous, benefit: diversification. Instead of trying to create one “Holy Grail” strategy that will likely stop working at some point, why not create 10-20 “good” strategies?
The net effect of combining the right strategies in the right way can be a Holy Grail in and of itself, as shown in Figure 3. Trading uncorrelated strategies guards against failure of any one strategy, and at the same time produces a smoother equity curve. Building multiple, unique strategies is definitely worth considering.
It sounds simple, but the trader will likely spend a lot of time figuring out the nuances of the new market, and likely lose money during this transition period. Taking for granted that a general trading methodology will work for all markets can be a dangerous assumption.
Obviously, many strategies or techniques that work in one market will probably not work in another market. A currency trading program, for example, likely relies on exploiting long term trends. Such an approach would likely not fare as well with stock market indices, which tend to be more mean reverting, with a long term upward bias.
Therefore, while trading a new market may be desirable, it might only be possible with the third radical change a trader can make: trading new and different strategies.
Changing Strategies
A third way to “teach an old dog new tricks” is to plan for strategy obsolescence upfront, and build an approach that embraces it. What does this mean? Simply put, the trader creates multiple strategies and makes the assumption that each strategy will eventually stop working.
It may not happen for one year, five years or fifty years, but assuming a strategy will eventually be ineffective, and planning accordingly (by using appropriate risk management) is a much better alternative to assuming a strategy will work for eternity.
How is this accomplished? Traders who embrace this approach will continually build new strategies. The strategies will be different styles, different timeframes and different markets. The key is that each strategy by itself must be properly developed and tested, and must demonstrate a long term positive expectancy.
One can think of it as the R&D function of a company. New strategies, like new products or services, are continuously created and then moved on to production. The process ends only when the trader decides to give up trading.
Building and trading multiple strategies, in addition to keeping the trader’s approach fresh with the current market, also has an overlooked, but tremendous, benefit: diversification. Instead of trying to create one “Holy Grail” strategy that will likely stop working at some point, why not create 10-20 “good” strategies?
The net effect of combining the right strategies in the right way can be a Holy Grail in and of itself, as shown in Figure 3. Trading uncorrelated strategies guards against failure of any one strategy, and at the same time produces a smoother equity curve. Building multiple, unique strategies is definitely worth considering.
The Way Forward – Conclusion
There are many ways to stay ahead of the trading game. For those willing to radically change their trading, incorporating different styles, such a discretionary trader learning algorithmic trading, may be a solution. For traders specializing in a particular market, transferring the tools and techniques to a new market can be a viable solution. Finally, mechanical or systematic traders can simply develop more and more strategies, and incorporate new strategies into their arsenal while simultaneously retiring underperforming strategies.
The objectives in all three scenarios is to stay one step ahead of the trading marketplace. With new traders coming online everyday, and trading technology growing at a fever pace, it just is not enough to be a static trader, trading the same way year after year. As the saying goes, the trader must learn to “adapt or die.”
There are many ways to stay ahead of the trading game. For those willing to radically change their trading, incorporating different styles, such a discretionary trader learning algorithmic trading, may be a solution. For traders specializing in a particular market, transferring the tools and techniques to a new market can be a viable solution. Finally, mechanical or systematic traders can simply develop more and more strategies, and incorporate new strategies into their arsenal while simultaneously retiring underperforming strategies.
The objectives in all three scenarios is to stay one step ahead of the trading marketplace. With new traders coming online everyday, and trading technology growing at a fever pace, it just is not enough to be a static trader, trading the same way year after year. As the saying goes, the trader must learn to “adapt or die.”
About Author: Kevin Davey is an award winning private futures, forex and commodities trader. He has been trading for over 25 years.Three consecutive years, Kevin achieved over 100% annual returns in a real time, real money, year long trading contest, finishing in first or second place each of those years.
Kevin is the author of the highly acclaimed algorithmic trading book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.
Kevin is the author of the highly acclaimed algorithmic trading book "Building Algorithmic Trading Systems: A Trader's Journey From Data Mining to Monte Carlo Simulation to Live Trading" (Wiley 2014). Kevin provides a wealth of trading information at his website: http://www.kjtradingsystems.com
Copyright, Kevin Davey and KJ Trading Systems. All Rights Reserved. Reprint of above article is permitted, as long as the About The Author information is included.