Let’s get messy

I’d like to talk about something that makes many traders feel uncomfortable.

It’s to do with mechanical trading systems. You know, the sort you buy out of a box, that offer you untold riches, and tell that you’ll never have to do more than click a button on your keyboard once a day?

Well, I want to confront some truths about these kinds of strategies.

Mechanical trading rules are brilliant and work really well …

… right up to the point that they stop working.

That’s right – no purely mechanical trading system will keep on working, unchanged, indefinitely.

It might work for a few weeks … for a few months … or a few years …

But ultimately, if you do nothing to update your trading strategy, eventually it will stop working.

Why?

Well, here’s what billionaire chairman of Oaktree Capital Management, Howard Marks says on the subject:

“The reasons are simple. No rule always works. The environment isn’t controllable, and circumstances rarely repeat exactly. Psychology plays a major role in markets, and because it’s highly variable, cause-and-effect relationships aren’t reliable. An investment approach may work for a while, but eventually the actions it calls for will change the environment, meaning a new approach is needed … Investing, like economics, is more art than science. And that means it can get a little messy.”

So, am I telling you to bin all efforts at finding a mechanical trading system, with clear rules?

No.

But Marks is 100% correct in what he says.

So, what should we do about this problem?

First off, let’s understand what’s causing the problem …

I’ll need to look at a bit of theory here …

Back in the days when traders wore bowler hats, there was a theory called the Efficient Market Hypothesis. Amazingly, this theory is still banded around by some – although generally by people who have never actually traded.

The theory goes something like this … we get information about the fundamentals of the market … traders make rational decisions on that information … and prices reflect genuine values.

Hmmm.

George Soros has an alternative theory on the markets, called Reflexivity.

According to Soros, we get information about fundamentals … traders make decisions on that information … the decisions traders make then affect the fundamentals … and so on.

This gives us a circular loop – just like feedback on an amplifier, where the reactions of traders affects the way other traders behave. It’s how markets get hyped up to create bubbles. And how panic spreads to cause crashes.

The gist is that markets just aren’t efficient machines, because the human beings who trade them are affected by emotions – we overreact to situations, we become complacent in bull markets, and we panic in bear markets.

Markets are messy.

The solution

The best traders I know have very strict trading rules that they follow. But – they are constantly monitoring those rules, adapting them, and keeping them in tip-top condition.

I don’t mean just chopping and changing, willy-nilly.

I’m talking about serious testing (back testing and live testing) of any adaptations, to ensure they’ll make results better.

People sometimes laugh at us traders, forever chasing after some “Holy Grail”. But the truth is that we’re not on some futile journey looking for something that doesn’t exist. It’s just that our Holy Grail is constantly morphing and adapting – and must be always trying to keep up with that.

The mechanical systems must be kept fresh.

When Martin Carter, the creator of MRP came to me with his enhanced trading indicator for the system, my reaction was: “Martin, the system is doing really well, why the heck would you want to change anything?”

The thing that Martin knows (and that I’d forgotten) is that when we’re riding high, we’re at biggest risk of tumbling off a cliff edge. Winning runs are exactly when traders become complacent, take risks, and come a cropper.

And Martin proved his point brilliantly with his enhanced indicator – which hasn’t missed a beat, adding ever more winners to his strategy. In fact, I’ve just bagged by 33rd winner in a row this week!

(NB: Martin Carter’s MRP strategy is now available as Diff Code Europe: www.diffcode.co.uk)

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