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Risk Management

Systematic Trading is Hard but Discretionary is Even Harder

A few excerpts from articles to our subscribers from this week on the perils of discretionary trading and looking at the wrong indicators.

This past week was marked by volatility in both stocks and bonds. Many discretionary traders were squeezed in both markets regardless of trade direction due to wide swings. This was also true in volatility market with VIX rising slightly above 21 but ending the week at 16.18.

About the perils of ignoring a prevalent dynamic in the stock market in the last 12 years but relying on fundamentals and news: short squeezes.

A large component of uptrend momentum in stocks and bonds comes from squeezing out shorts. Any directional gains due to squeezes are unrelated to fundamentals or technicals. Shorts are usually squeezed because they have significantly less purchasing power than longs. This market dynamic is quite prevalent in the last 12 years in both stocks and bonds. However, there are many traders, especially retail, who either fail to understand or refuse to accept this dynamic but constantly blame the Fed and central banks for their losses…  It is better staying out of the market when it is on a downtrend and investing in something that has potential to go up than shorting due to possibility of short squeeze moves even in bear markets. The variance due to those losses decreases significantly any longer-term growth potential. But this is another fact many traders do not understand.

Blaming the Fed for bad discretionary trading decisions: How volatility drag kills geometric returns.

There are many traders in forums and social media who haven’t been able to make any money this year and are angry while they are putting the blame on the financial system and the central banks. Trading is hard but discretionary trading driven by news, social media posts and random articles in the financial blogosphere is even harder. Even when not paying attention to random information but relying on experience, discretionary trading is hard because the volatility of returns contributes to a steady decline in profitability. Although the mean return A of the trades may be positive, due to high variance V, the geometric return G becomes negative according to the formula: G ≅ A – V/2. This is one of the reasons many traders allocate only small percentage of their equity to discretionary decisions. Using strategies is not sufficient for profitability but may be necessary. Usually after reviewing signals generated by strategies one may notice some that were not intuitive at all. The simple reason for that is that mathematics has no emotions and cannot be affected by external noise.

On the perils of relying on methods used in the past century in a mean-reversion environment.

Traditional technical indicators and macro analysis belong to past century. Markets have changed, especially in the last 12 years. Chart patterns, trendlines, dual-axis macro charts and most of analysis used in past century is no longer relevant in an environment where the predominant force that drives price action is mean reversion.

Conclusion:  There are many ways to lose but only few to stay in the game with potential of winning: systematic trading, understanding market dynamics and relying on relevant methods.

Disclaimer:  Nothing in this blog constitutes a trade recommendation. Read the full disclaimer here.

Charting and backtesting program: Amibroker.

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