Originally published on getdailybuzz.com
Systematic trading, sometimes known as mechanical or system trading, is an effective mechanism for a certain type of trader. A well-designed systematic trading model is a rule-based algorithm that has fully defined entry and exit indicators. It is a mechanism designed to adjust a portfolio’s position based on calculations made from a specific set of market signals. It removes human intervention and makes adjustments based solely on the output of the model’s algorithm.
Because there is no human intervention, a good systematic trading model may provide lower risk but may not have the ability to leverage market anomalies that could indicate exceptional opportunity.
Systematic trading models are popular among hedge funds and other risk-averse traders. Both system traders and discretionary or decision-based traders share the same potential for profitability. The decision to be one over the other is often based on the trader’s personality type.
Traders who value the time they invest in learning and applying trading principles and are willing to accept additional risk as they develop their skills often make satisfied decision-based traders. On the other hand, those who are able to process historical data and find market edge in historical patterns are often more attracted to system trading. Developing a trading system and actually following it are two very different matters. If your back tested trading system experienced several -30% drawdowns, but you are unable to stomach a -30% drawdown in cash trading, then you are most likely not going to be able to execute your strategy in real time.
With decision-based trading, a trained human uses their expertise and market knowledge to determine entry and exit points. “While humans are capable of factoring in large amounts of information, they are also more susceptible to making emotion-based decisions. Emotion-based decisions often inject additional risk into the decision-making process,” stated Daniel Calugar, a data-driven investor.
Decision-based trades are made because of the trader’s perception of the current market conditions. Depending on the experience and skill level of the trader, that perception may or may not be accurate.
An excellent systematic trading model should over the long term provide superior returns without frequent adjustments or modifications. You should keep in mind, however, that if you are seeking equity returns, you must be willing to take risk and you will experience periods of time that your models do not outperform the market. Because each model is specifically designed to produce predictable results for a specific portfolio under a given set of circumstances, single models are usually only one element of a more extensive trading program.
A systematic trading program is a collection of trading models assembled to provide a level of asset and strategy diversity. Because a systematic trading model is a simple mechanism, a single model will not offer diversity for protection against drawdown periods. Multiple models applied to a single portfolio can provide the needed protection.
A systematic trading program is only as good as the models included. A model is only as good as the information that is input. Once the rules and objectives have been clearly defined, the model will provide unparalleled speed, accuracy, and precision. By combining the suitable models for your program, you can achieve the benefits of systematic trading across a diversified portfolio.
When deciding whether to use systematic or discretionary trading to advance your portfolio, evaluate your risk appetite. If you have a healthy appetite for risk and the time and expertise to make your own trading decision, discretionary trading may be for you. On the other hand, if you value speed, accuracy, precision, and rules, a systematic approach may be more appealing.