Last Updated on January 13, 2022 by Oddmund Groette
Why do trading strategies stop working?
Strategies stop working mainly because of curve fitting, structural and cyclical changes, survivorship bias, behavioral mistakes, commissions, and slippage. Short-term trading is a zero-sum game and you need to accept that trading strategies at one point stop working. You better be prepared!
Imagine yourself having one or several trading strategies that are literally handing you money on a silver plate. Then one day everything stops working and you are stranded with no strategies that seem to work.
Unfortunately, trading strategies do stop working. In this article, we look at reasons why trading strategies are not working and how you know a trading strategy stops working.
Understand why strategies are not working
To better understand why a strategy is not working (or perhaps stops working), you need to understand why trading strategies fail:
Not long enough backtest and no out of sample test
A backtest needs to generate many trades to be of any significance. Moreover, it needs to be of significant length. A lot of traders only use a small time frame and thus are more liable to randomness and cyclical trends in the market.
Put simply, most trading strategies are not adequately backtested. Some strategies work fantastic a couple of years before they fade away. Breakouts might work in a rising market, but less so in a sideways and falling market. Be sure to test in all types of markets.
And make sure you have a proper out of sample test:
Trading strategies stop working because of curve fitting
When something is curve fitted, it is just a question about time before it ends up useless. Curve fitting happens because of too many parameters and criteria and too short a time period for the backtest.
The best trading strategies for the long term are those which have the fewest parameters:
Structural change makes trading strategies obsolete and they stop working
We had great success for some years trading the opening imbalances at the open on NYSE. But all good things come to an end, and the change to electronic trading made the specialist system almost obsolete. Thus, our best strategies simply stopped working.
How the stock exchanges operate has a tremendous impact on how strategies work (or do not work). Legislation and impact have a huge impact.
Cyclical change makes trading strategies difficult to trade and follow
Some strategies work well in certain types of markets and not so well in others.
For example, trend following has always had many years of underperformance before they start working again. This makes them very hard to follow and trade, and that’s perhaps the reason why they seem to work in the long term.
The Dogs of the Dow was once a very good strategy but less so the last ten years. Is this cyclical or a structural change? Permanent or temporary? We don’t know but the markets have evolved and changed since the strategy became very popular.
For example, Ben Bernanke started quantitative easing and this has had a huge impact on asset prices and behavior. Is this permanent or temporary? We don’t know, but it sure changed the market!
Being dependant on one type of strategies
Some only trade mean reversion, and others only trade trend following. Likewise, some are day traders and some are swing traders.
We believe this is a mistake for many aspiring traders. You should be agnostic and trade anything that works.
One dollar made in crude oil is the same as one dollar earned in day trading Microsoft. One dollar made day trading is the same as one dollar made in a weekly time frame. We believe the most rational approach is to diversify to different time frames. Why? Because not all time frames stop working at the same time.
Strategies are not working because of survivorship bias
This is something all traders ignore (or forget). They tend “forget” because survivorship bias should be just a minor problem – a detail?
No, unfortunately, survivorship bias can have a huge impact. We have covered this in a separate article which we strongly recommend reading:
Behavioral mistakes make you not follow the signals of the strategy – thus you have no strategy
The first requirement to a trading strategy is that you should trade all signals the strategy tells you to do. But trading biases always put a spanner in the works. It’s easy to skip a trade after four losses in a row or if you are in a drawdown!
But this means, in reality, that you don’t have any strategy in the first place if you skip trades. It’s almost impossible to know before you trade a signal if it’s going to be a winner or loser. The markets are unpredictable and usually not intuitive. You have not backtested omitted trades, and thus you have no strategy. Many quants become discretionary traders by skipping trades.
Commissions and slippage are underestimated
Because of structural changes, like described above, slippage might increase or decrease depending on certain factors. For day traders this might be the difference between a lot and nothing.
Inefficiencies get arbed away
Eventually, all inefficiencies in the markets get arbed away. A strategy can become too well known, for example, when a book is written about the strategy.
Short-term trading is a zero-sum game
Always keep in the back of your head that short-term trading is a zero-sum game. If you invest for the long term, you get a tailwind from the gradual increase in prices (inflation) and earnings growth. This takes time to get reflected in increased share prices, but traders don’t have this luxury.
The options and futures markets are a 100% zero-sum market – even negative considering the costs. What you make, someone else must lose.
Because trading is a zero-sum game, you can’t expect trading strategies to work forever. They sooner or later stop working:
All trading strategies stop working – sooner or later
If you find a good trading strategy you need to accept that sooner or later it will stop working – preferably later, of course.
This is the sad fact of trading. If you’re a long-time buy and hold investor, you don’t need to worry about this. But if you’re a trader, you need to understand that trading is a constant battle of having an arsenal of trading strategies.
How do you know a strategy stops working?
If you know that all trading strategies sooner or later stop working, you are somewhat prepared.
The truth is, perhaps sadly, that the future is unknown. On the other hand, this is what makes life worth living. If all was plain sailing it would be rather dull and boring (?).
What do you do to prepare for the time when your trading strategies stop working? Do you panic and turn off the strategy? Or do you just keep on plugging as if nothing happened?
The main problem in trading is that there is no way for sure you can tell if a strategy is finished or just in the middle of a normal and expected drawdown.
However, if you have a clear idea of why the strategy is working in the first place, or at least why it should work, you can better tell if you should continue or stop trading the strategy.
The markets are non-stationary and adaptive, and thus trading strategies stop working (sooner or later).