Systematic Trading

A unique new method for designing trading and investing systems

Robert Carver

• Publisher: Harriman House
• Year: 2015
• ISBN:
  9780857195005
• Edition: 1
• Topic: Business
• Subtopic: Stocks
• Index: Business

This is not just another book with yet another trading system. This is a complete guide to developing your own systems to help you make and execute trading and investing decisions. It is intended for everyone who wishes to systematise their financial decision making, either completely or to some degree. Author Robert Carver draws on financial theory, his experience managing systematic hedge fund strategies and his own in-depth research to explain why systematic trading makes sense and demonstrates how it can be done safely and profitably. Every aspect, from creating trading rules to position sizing, is thoroughly explained. The framework described here can be used with all assets, including equities, bonds, forex and commodities. There is no magic formula that will guarantee success, but cutting out simple mistakes will improve your performance. You'll learn how to avoid common pitfalls such as over-complicating your strategy, being too optimistic about likely returns, taking excessive risks and trading too frequently. Important features include: - The theory behind systematic trading: why and when it works, and when it doesn't.- Simple and effective ways to design effective strategies.- A complete position management framework which can be adapted for your needs.- How fully systematic traders can create or adapt trading rules to forecast prices.- Making discretionary trading decisions within a systematic framework for position management.- Why traditional long only investors should use systems to ensure proper diversification, and avoid costly and unnecessary portfolio churn.- Adapting strategies depending on the cost of trading and how much capital is being used.- Practical examples from UK, US and international markets showing how the framework can be used.Systematic Trading is detailed, comprehensive and full of practical advice. It provides a unique new approach to system development and a must for anyone considering using systems to make some, or all, of their investment decisions.

Part One. Theory

Chapter One. The Flawed Human Brain

Human minds can do wonderful things, but are deeply flawed when making financial decisions. In this chapter I explore economic theories about human behaviour, and why systematic trading and investing makes sense. I also show how our irrationality can interfere with the design of systematic strategies.

Chapter overview

Humans should be great traders, but...	The research that tells us why humans make bad decisions.
Simple trading rules	The dumb systems that are better at investing and trading than clever humans.
Sticking to the plan	Why you must be committed to your systems for them to work.
Good system design	Avoiding the human failings which can still be dangerous when designing systematic trading strategies.

Humans should be great traders, but...

Why do we need to trade or invest in a systematic fashion? What is wrong with using our own intuition to trade in a discretionary way? After all our brains have an astonishing ability to absorb and react to complex data, like those we see in financial markets. In my own Barclays trade described in the introduction I did analysis that would be virtually impossible to replicate with a systematic rule. But a simple rule would have been more successful than I was.7

Unfortunately there have been many other times when a systematic strategy would have made better decisions than I did. For example in 2004 I bought some shares in UK oil company BP. They quickly rose about 5% and I sold them for a small profit. They subsequently rallied to a much higher level. I resolved never to sell too quickly again.

Then in late 2009 I decided to recycle some of my Barclays profits into buying BP. Initially they went from £5 to over £6. But in April 2010 one of BP’s drilling rigs exploded in devastating fashion, killing 11 people. The shares started to fall, and a month later they were back at £5. Scarred by my earlier experience I hung on, convinced they would rebound. I finally sold at £3, which turned out to be the bottom.

I got it wrong both times. Was this just bad luck – a BP jinx? Am I a particularly poor trader, or is this evidence of a deeper problem with human psychology?

In fact despite their awesome complexity human brains like mine, and yours, are fundamentally flawed. In the jargon they are subject to cognitive biases which result in irrational behaviour. These instincts are so strong they mostly overwhelm any natural advantage that humans should have over simple decision-making rules.To see why this happens we need to understand how economists have tried to model and understand human behaviour.

The death of rational economic man

When the ideas of classical finance were developed in the 1950s economists assumed that people behaved in a purely rational way, resulting in perfectly efficient markets. Over time many apparent anomalies in this theory were discovered. But these were easily dismissed by the academic establishment as irrelevant, statistically insignificant or explainable through some combination of risk factors. Crucially nobody was able to come up with an alternative model that was as self-consistent and elegant as the efficient markets hypothesis.

From the 1980s onwards the field was penetrated by researchers from the discipline of psychology. For these experts in the human mind, the economist’s framework of pure rationalism must have been highly amusing. A key insight these academic interlopers brought was that our brains are loaded with baggage from the distant past.

Parts of our grey matter are still hardwired for survival in a hostile environment where quick thinking was better than slow thoughtful consideration. As a result we have deep-rooted instincts that make it extremely difficult to behave in the rational way that classical finance expects. The new field that the interlopers created was behavioural finance, and it did have its own unifying model: prospect theory.

Why we run losses and stop out profits

Prospect theory explains why investors get it wrong when confronted with certain trading decisions, such as whether to sell out of a position which is now showing a loss. Most people show the greatest reluctance to take losses, as I did in 2010 with BP.8

This has been catchily described as “get-evenitis” by Hersh Shefrin.9 This aversion to taking losses is a very powerful instinct. Humans do not seem to view a paper loss as real until it has been crystallised, so we can postpone the painful feeling of losing money. We are also reluctant to admit that we made a mistake with our initial purchase. Selling is an admission of failure.

Conversely, if a ...