Last Updated on June 19, 2022 by Quantified Trading
How can you avoid or minimize that trading strategies stop working? This is one of the most important aspects in trading because trading strategies stop working – sooner or later. Many traders would hope a strategy lasts forever, but markets are not meant to be static. Markets are dynamic and evolve and change both gradually or suddenly.
The better the foundation of your business plan, the fewer trading strategies stop working. The more you prepare for inevitable trading hiccups, the less they matter. Below we have made some ideas on how to avoid or minimize trading strategies stop working.
Trading is all about backtesting and generating ideas
Markets change all the time. Good traders know this and adapt by constantly looking for ideas to put into live-action. By being prepared you minimize the damage when strategies stop working.
Any quant trader should spend at least 80% of their time backtesting and brainstorm for ideas. There are plenty of ideas both for free and as subscription services on the internet, even some on this website:
What are the chances of finding a tradeable trading strategy? Probably around 1 in 20 backtests show promise. Of the one in 20 that passes our backtesting criteria, very few make it past the incubation period (see below).
As you can understand, this is a time-consuming process! But in the long run, you get rewarded because you’ll have fewer strategies that stop working and your trading becomes more robust.
Proper backtests minimize strategies stop working
Make sure you have tested your strategy over many years and in many different investment climates.
For example, the bull market from 2008/09 has been pretty long and all driven by quantitative easing from central banks. Prior to 2008/09, there was no quantitative easing. Thus, the momentum strategies that work now will most likely face a pretty hard time when the easing stops.
Included in a proper backtest is out-of-sample testing. Divide your dataset into two parts: one for in-sample and one for out-of-sample. Read more here:
As explained in the link above: an incubation period of many months can save you a lot of money:
Incubation period: test every trading strategy live in a demo account
When you have found a strategy that looks promising in a backtest, you should paper trade it for many months in a demo account. We like to call this the incubation period. It’s time-consuming but this “trick” saves you money in the long run and makes it less likely your strategies stop working. And when your strategy stops working, you are prepared for it.
If you have done a live test and are pleased with the result, you can start trading it live. The majority of the trading strategies we test via incubation never make it to live trading with real money.
The strategies that pass the incubation period normally last for many years. The incubation period is an excellent way of minimizing the strategies that stop working.
Simplicity reduces strategies stop working
Many traders spend months tweaking one “super strategy”. We believe this is wrong for two reasons:
First, you risk curve fitting or going round in circles. You should be very careful in changing parameters, at least only after rigid backtesting and incubation.
Second, you risk ending up with more parameters than necessary (and thus curve fitting). The best trading strategies are always those which have the fewest parameters.
Structural edges are less likely to stop working
In our opinion, the best trading strategies are those that are based on some structural edges.
By structural edges, we mean an edge that is built on how an exchange operates, for example. The specialist system on the NYSE is another example of what we consider a structural edge.
Another example of a structural market edge is the turn of the month effect (this one could be labeled cyclical as well). We suspect this effect happens because investors and savers allocate more money to stocks at the end and the beginning of each month.
We believe it’s easier to diagnose any problems with structural effects than many other edges and they are less likely to stop working.
Always quantify your ideas
We believe automation is superior to discretionary trading. Automation has two main advantages.
First, you can trade and execute an unlimited amount of strategies. The computer does all the trading for you.
Second, you minimize second-guessing and behavioral mistakes. The less you stare at the screen, the less likely you are to screw up by doing something not planned. The fewer screw-ups, the less likely a strategy stops working.
Why? Because many strategies stop working because you start tweaking your strategy or skipping signals. Automation removes many behavioral mistakes.
Look for abnormalities
Abnormalities normally revert to the mean, but of course, not always. Trading is a numbers game.
Stock prices are not normally distributed, sometimes we get a black swan, but we believe mean reversion is the lowest hanging fruit in trading.
- Trend following strategies and systems explained
- How to create a mean reversion trading strategy
- Which time frame is best in trading?
Correct position sizing
Setting together a portfolio of trading strategies is not easy. The thing that complicates the most is the position sizing.
For example, if you trade 5 different strategies in stock indices, do you just trade one signal at a time (not taking a signal when you already have a position), or do you still trade the signal to increase your overall exposure?
Are you tempted to increase size after a period with good results? There are many temptations to adjust the position size along the way, and often it will be the wrong thing to do.
Wrong position sizing makes you believe a trading strategy has stopped working, but in reality, many times it all boils down to the correct size of your positions.
Our best advice on position size is to trade smaller than you like:
Prepare for drawdowns by trading small
Always trade smaller than you like. If you have a good strategy or a good period, it’s very tempting to increase size in the belief that you’ll make more money. Many want to get rich in a hurry!
But it’s not that easy. If you get in over your head, you make inevitable mistakes, especially behavioral mistakes. Many increase size after a good period, only to lose more when the inevitable drawdown happens. During the drawdown, you reduce size….. This is a vicious cycle you want to avoid.
The best medicine for avoiding behavioral mistakes is to always trade a little smaller than you would like. If you want to get rich in a hurry, you increase the risk for a substantial setback sooner or later when strategies stop working.
Make sure you use the Holy Grail of trading – diversify
The Holy Grail of trading is having many different trading strategies that are uncorrelated to each other. That is, of course, difficult, but it should be your goal.
When you can trade an unlimited number of strategies, only your imagination and idea generation stop you from trading plenty of strategies. You should diversify on markets, time frames, and types of trading strategies.
This is a topic we have covered before in these articles:
- What is this the Holy Grail of trading?
- How to deal with drawdowns
- What does correlation mean in trading?
- Why build a portfolio of quantified strategies
The point with diversification is to have strategies offset each other but still make a positive return.
Thus, when your strategy stops working, you are prepared. It’s not likely that all your strategies fail you at the same time if you are properly diversified.
Conclusion: How to avoid or minimize trading strategies stop working
You can’t eliminate the risk that your trading strategies stop working, but you can prepare for it and minimize the risk.
You avoid or minimize trading strategies stop working by making proper backtests with many months of incubation testing in a demo account, you diversify into strategies by trading different assets and time frames, and you look for trading edges where you can have a sustainable edge.