It is much easier to trust a system which is objective. Firstly, because it is transparent: you know given some particular data exactly what the positions should be. Secondly, you can back-test an objective system over history. This will give you an indication of what its past behaviour was, and how it should trade in the future. For example suppose a system typically lost around 5% on one of every ten trading days in the simulated past of your back-test. You shouldn’t worry if in real trading you lose 5% every couple of weeks.16 (View Highlight)
It is carefully built from ideas or data Systematic trading assumes the future will be like the past. Hence you should create rules that would have worked historically, and hope that they will continue to work.
But there are at least two different ways to find rules that made money in the past. One common method, which I call data first, is to analyse some data, find some profitable patterns and create some trading rules to exploit them. This is sometimes called data mining. The alternative, ideas first, is to come up with an idea, then create a rule, which is then tested on data to see if it works.22 (View Highlight)
target (the average amount of cash you are willing to risk). You can then design each component independently of the other moving parts.
Trading rules and stop losses should be based only on expected market price volatility, and should never take your account size into consideration. Calculating a volatility target, how much of your capital to put at risk, is a function of account size and your pain threshold.72 Positions should then be sized based on how volatile markets are, how confident your price forecasts are, and the amount of capital you wish to gamble. (View Highlight)
“You need to know three things. First, how much do you like this trade? That comes from here,†Sergei replied, pointing to his heart.
“Second thing, how much can you afford to lose? That is down here, in your gut,†and he patted his extensive stomach.
“Last thing, how risky is it? You calculate that here.†said Sergei, tapping his forehead.
His answer was unhelpful, completely lacking in any detail, but totally correct. (View Highlight)
It’s not enough to predict that prices are rising or falling; you also need to decide whether they will go up a lot, or a little. You need to decide how much you like the trade. You need a forecast – a prediction of how much prices are expected to go up or down. (View Highlight)
A forecast is a number: a positive value means you want to buy the asset because the price is expected to go up and a negative indicates you want to short the asset. Investors who don’t use derivatives and can’t short sell will only make positive forecasts. A forecast shouldn’t be binary – buy or sell – but should be scaled. Forecasts close to zero indicate a small movement in prices and larger absolute values mean you expect bigger returns. (View Highlight)