Is there an immortal trading strategy?
Everything in the world follows the law of conservation of energy. Trading strategies are no exception. The real challenge for quantitative traders is knowing that the strategy will grow old one day but never knowing which day it is.
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NO. 2 Different views
Some people think that the future market is constantly changing. A mature and stable trading strategy should suit for all future markets, whether it is a unilateral market or a volatile market.
Others believe that different strategies suits different markets. Even if the trading strategy is strictly tested, once the trading strategy has passed the life cycle, it should be re-examined to see if it still has a solid profitability.
Before discussing this issue, let's look at an example—from the time of its inception in 1985 to 2005, Gotham Capital, led by Joel Greenblatt, created an investment miracle of making $7 million to $830 million with an average annual return of 40%.
In 2005, Joel published a 150-page book, “That still beats the Market,” which condensed his investment experience into an easy-to-understand “magic formula”: select the top 20-30 stocks form in a comprehensive ranking of high return on assets and low P/E ratio buy separately and sell them one year later.
This “magic formula” is a simple quantitative model. If following Joel’s investment method, the investor’s portfolio return rate will reach 30.8% during the 17 years from 1988 to 2004, while the Standard & Poor’s 500 Index’s compound annual return is only 12.4%.
It looks beautiful, but Joel also pointed out the weakness of the magic formula.
“The magic formula has a bad performance of 5 months in average during the 12-month test period. During the whole year, the magic formula cannot defeat market every 1 year for 4 years. Taking 6 years as a test period, the formula has not been as good as the market for two consecutive years. For 17 years, the performance of formula is not as good as the market even for three consecutive years.
Three consecutive years of bad performance – which means that if you make a quantitative hedge fund according to the magic formula, you will suffer losses for three consecutive years.
When a strategy temporarily fails, do you suspect that the strategy is old? Or temporarily ineffective? Can you handle that? （FMZ)
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NO. 4 Reflexivity of strategy
Why the strategy fails, the most representative explanation should be reflexivity. In the book The Alchemy of Finance, Soros mentioned in explaining the theory of reflexivity: When you observe the market and enter the market, the market is not the market you originally studied.
That is to say, when a certain trading strategy in the market continues to be effective, more and more such strategies will be added to the market, and the original effective strategy will gradually become ineffective. Conversely, when a failed trading strategy has passed over a period and more and more people abandon this trading strategy, then this temporarily ineffective strategy will slowly become effective. It’s just like a circle.
"You can win the next game, but you can't win all the games." Sometimes you should be determined to enter, sometimes you should do nothing. As a quantitative trader, you should execute your trading strategy seamlessly. If not, once there is a sharp drawdown, you won’t know the problem is the trading strategy or not following the trading strategy.
Objectively speaking, a problem related to the success or failure of a transaction and survival is also a problem that is difficult to be solved perfectly. No matter what assumptions your trading strategy is based on, no matter which method you use, when this assumption does not exist, you must pay the price. No one will find it ineffective before the strategy fails. This is a necessary cost.
Although we can't accurately determine if the trading strategy really fails or it will become effective again after the temporary failure, but we can still take some measures to cope with the possible situation.
NO. 6 How to deal with
When we judge whether the trading strategy is still effective, the first problem to be faced first is that this strategy is temporarily ineffective or permanent failure?
In the face of this problem, we can examine it like this:
- The drawdown has exceeded 1.2 times that of the maximum drawdown in backtesting.
- The maximum loss per day exceeds 1.2 times that of backtesting
- The maximum loss per week exceeds 1.2 times that of backtesting
- The average profit is lower than 0.8 times that of backtesting.
- The number of failures continues to rise.
In the real market, when one or more of the above-mentioned situations appear, be careful, which may be a temporary failure of the strategy or a permanent failure. If this happens, first stop the strategy and continue to use the simulate market for verification until it passes the test.
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The trading market is a complex environment. In a stable environment, complex trading strategies are more resilient, and complex trading strategies are superior to simple trading strategies. But once this ecological environment changes, complex trading strategies are more likely to fail.
A robust trading strategy has three main points: First, the trading strategy can adapt to most different market conditions; second, the trading strategy remains simple, and the simple strategy is not susceptible to changes in the market environment. Third, the risk management is simple.
A trading strategy that performs well in a particular period is less able to adapt to the future environment. The profit speed and the robustness are opposite, and the trading strategies that are effective at the micro level are macroscopically weak. Therefore, a long-term effective trading strategy is very flat in a certain period.
If the time is long enough, no matter which strategy will eventually fail one day, like a perpetual motion machine, there is no such thing as an immortal new trading strategy in the market. No matter how much energy you put in, how confident you are, be prepared to fail. Because this is part of trading, if you cannot accept, stay away from it!
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