Trading style drift

September 26, 2015 09:00 AM

We’ve all heard the saying that 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 persist through the immense price drops (see “Down and out,” below) or did they adapt and find new tricks; new ways to generate returns from the markets? In a similar way, many followers of the so-called “Turtle” trading method that was based on Donchian breakouts have found it 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 make money forever. The best traders are constantly researching and developing new strategies and adapting their methods to survive in an ever-changing marketplace. This constant adaptation can take many forms: Changing of styles, changing of timeframes, changing of markets traded or changing of strategies employed are some examples. 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 style of trading. When pressed, we all identify ourselves as a certain type of trader: Discretionary day trader, systematic long-term trader, option writer, etc.  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 alpha-generating. 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?

The answer, of course, is that it depends. For example, so far in 2015 many options traders (likely premium sellers) have been reporting excellent returns, while many trend-following futures traders have been struggling to keep pace. In years past, the exact opposite was true. 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. Or, if he were really sharp, instead of trading all three methods simultaneously, he could switch from method to method as the market favored one approach versus another.  

Certainly, there are drawbacks to such a multi-pronged approach. First, it is easy to become a jack of all trades, yet 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 working at the time. 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 realized results would reflect that. It is important that a trader defines various market environments that each style performs well in and apples the appropriate style for each environment. A trader shouldn’t simply switch styles after one bad trade. 

While changing styles of trading or trading multiple styles at the same time could work, there might be better methods of adapting. One possibility is to change the markets themselves.
changing markets

Ask any short-term euro currency trader what 2014 was like, and they’d probably respond “awful.” As shown in “Slow ride” (below), euro volatility reached historic lows in 2014. While this might have been good for some options strategies and long-term trend-followers getting short in the second half, for most day traders the prospects were minimal. Simply put, if the market price does not move, there is little opportunity for profit.

The easiest way to handle a “dead” market is simply to 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 could struggle during this transition period. Taking for granted that a general trading methodology will work for all markets can be a dangerous assumption, but it is easier and less disruptive to apply a proven method to a different market than to come up with a completely separate strategy. 

Obviously, many strategies or techniques that work in one market probably will not work in another. 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 indexes, 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 adapt is to plan for strategy obsolescence up front, 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 eventually will stop working. It may not happen for one year, five years or 50 years, but assuming a strategy  eventually will be ineffective, and planning accordingly (by using appropriate risk management) is a much better alternative to assuming a strategy will work for eternity.  

Traders who embrace this approach continually will build new strategies. The strategies will be different styles, different time frames 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. Think of this as the research and development function of a company. New strategies, like new products or services are created continuously 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 reasonably profitable but more robust strategies instead? The net effect of combining the right strategies in the right way can be a holy grail in and of itself, as shown in “Reaping benefits” (below).  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

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 under-performing 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 who’s trading the same way year after year. 

We do not want to suggest that creating different trading styles and building multiple systems is an easy task. In fact, when evaluating investments, style drift is a red flag to watch out for. But markers constantly change and by continuously looking at different markets, time frames and strategies you can determine what works best in different environments. Not every new strategy will be a winner—in fact most will fail—but in the process you will likely find a way to improve an existing style if not an altogether better one. 
In the end, good traders adapt or die.

About the Author

Kevin J. Davey has been trading for more than 25 years. Kevin is the author of “Building Winning Algorithmic Trading Systems.”