How To Develop a Trading System: Part 2

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Abstract: This email sets the stage for all your future development and testing of trading systems. You are going to learn what makes a trading system work in the face of head winds like volatility. In fact, you are going to learn why headwinds will actually make your system stronger.

The Strategy Holy Grail

There are potentially many strategies behind a successful algorithmic trading system. These strategies should work to complement each other. And while some people are looking for that one perfect strategy, they will ultimately be disappointed, because as of yet, there is no perfect strategy, or the holy grail as some call it.

The reality is that strategies are as diverse as people on the planet Earth. And they come and they go. Some are effective for long periods of time, while others are flashes in the pan. And for the most part, you can’ predict which will be which.

This is why the perfect strategy is not the perfect standalone strategy, but rather the one that fits perfectly among other complimentary strategies, working together as a singular portfolio.

Diversity is the Key

The interesting thing about the power of diversity in trading systems is, that a diversity of strategies in just about any human endeavor is superior to a single stand-alone strategy. This “methodology,” or strategy of strategies is the key to achieving anti-fragile behavior.

Anti-fragile is a term that was made popular by philosopher and mathematician, Nassim Taleb, in a book he wrote called; “Anti Fragile – Things that Gain from Disorder.” It is a concept about a property possessed by many organic life forms, that get stronger when they are stressed. Humans are a good example. For instance, when a person exercises they create micro-tears in their muscle, and these heal, and grow the muscle to a state that was stronger and more resilient than before.

Many plants also have a similar capability. When saplings are first growing, the wind sways them back and forth, causing similar tears in their stalk, which then repairs itself, producing bark, which allows the plat to grow stronger and taller.

This same concept can be applied to all sorts of growth strategies, including financial growth strategies, like trading systems. The key component of such a strategy, first and foremost, is the introduction of stress into the systems. In finance, this stress is in the form of volatility. Without volatility, or something to induce stress, there will be no opportunity to let anti fragile behaviors do their work.

Hedging By Avoiding Correlation

First you have to understand one thing, and that one thing is the market doesn’t care what you think. The market is brutal and unpredictable. I won’t go as far to say the market is totally random, but for all intents and purposes, you can treat it as such…a totally brutal random monster that will take all your money and not even say thank you.

Investors for years have thought that the way to protect your assets was to spread the risk across a number of uncorrelated asset classes, like stocks, bonds, precious metals, real estate, and cash. The idea was that each of these assets classes performed a certain way during certain market conditions.

Stocks generally go up during good times, while bonds continue to pay dividends. Then when the market becomes bearish, bonds become stronger, hedging the drawdowns you might experience in stocks. Precious metals are generally thought to be a store of wealth, and a hedge against inflation, and we always need some amount of cash on hand to shift our asset allocations based on our perception of current and future market conditions.

Sounds like a well thought out strategy, right? WRONG!

Ever since the great crash of 2008-2009, whenever there is a market upheaval, or surprise economic event that causes a price shock…all assets classes have gone in the exact same direction. The strategy be damned!

With all your intelligence, and planning, and sticking to the experts, you still lost money. Hedging by diversifying assets simply doesn’t work. The stock market over the past 15-20 years, despite the huge run up since the crash, is essentially flat, with year over year returns under 2 percent.

So, what’s the alternative? Is there some secret asset class? What about real estate, or income property? They have been a roller coaster too.

Diversity of Multiple Non-Correlated Strategies

That’s a mouthful. Diversity of assets doesn’t work, but diversity of strategies that have no correlation to one another does, In fact, you could trade a single asset class and employ a diverse set of non-correlated strategies, and do way better than traditional asset diversification.

So, what does non-correlated strategies mean?

It means employing strategies that have nothing to do with each other. Strategies that react to completely unrelated data and aspects of the market. Strategies that show statistical non-correlation is the key, and it’s somewhat of a science. Not a terribly difficult thing to understand, but a science none the less.

Most people trade off of technical indicators, and they’ll use loads of them all at the same time and try to line them all up to give them what they think is the best opportunity or best signal. But all these technical indicators are derivatives of the same thing, and that’s price action.

So, if you employ 20 indicators, representing 20 strategies, but they are all based on the same underlying data…that is not diversity, that is NOT non-correlated. You will never get an edge trading like that. And it’s one of the reasons that so many people fail at trading, because they believe it’s just a matter of finding the right combination of indicators…

They are dead wrong, and the statistics prove they are wrong, with more than 80 percent of ALL traders losing money, and virtually all those traders fallowing the same old tired crap that’s being perpetuated around the world on trading.

Let’s Stop Here…as I’m getting a little long winded. The next email, I will explain what it means to have strategy diversification, and how to employ it.

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