Since the trading world started to go online, the use of technology has revolutionised the way successful trading strategies are developed.
This article highlights 3 main components of modern trading strategies that make them successful.
Introduction
When it comes to trade size allocation, have you ever been told with a broad brush to size every trade between 10-20%, depending on your risk preference?
Or you’ve signed up for trading courses because they promise 80-90% accuracy win rates, believing they are the holy grail and only to realise they aren’t eventually? How many of these professional trainers have actually shown you their historical win rates, or actually demonstrated the strategies that they teach you have been rigorously back tested with transparency? Perhaps all you have been shown are example charts and case studies of a few historical trades that worked? In reality, case studies are hardly enough to prove whether a given strategy actually works.
Maybe some of these strategies have taught you to only take trades with reward to risk ratios of at least 2:1? Perhaps you’ve tried them out and realise that despite you following the rules, the stop losses rack up more often than you actually win?
What’s been mentioned above, and perhaps many more, are common characteristics of these conventional trading strategies that have been around for many years.
Modern trading strategies are almost completely different from these ‘conventional strategies’, and they hardly adopt any of these common characteristics which is why they can be successful.
There are 3 common aspects of modern successful trading strategies, and they are unknown to many.
Win Rate is important, but not everything
Let’s begin by stating that most, if not all, investment and trading strategies are evaluated based upon their average annual returns. This means that there are 365 calendar days worth of opportunities for any strategy to prove they can generate positive profits, rather than begin judged based upon a few trades, or perhaps a shorter time frame.
Successful modern trading strategies take full advantage of this fact that they have 1 year to achieve their objectives. Because they have time and now technology (high processing computers) on their side, these strategies no longer require high win rates. All they need is a win rate that is slightly positively skewed (>50%) and another critical factor that we will cover below.
The world’s most famous hedge fund, the Medallion Fund by Renaissance Technologies (39.1% Average annual return 1988-2018), only has a 50.75% win rate1. There are also many successful high frequency trading (HFT) funds that have made a lot of money with only slightly positive win rates, similar to the Medallion.
TAKEAWAY 1
The most important thing to remember for a winning strategy is to have a > 50% win rate. Win rates don’t have to be overwhelmingly high, it just needs to minimally win more than it loses.
Law of Large Numbers
The next most important factor is trade frequency and the law of large numbers. The Medallion Fund is purported to stay in trades not more than a day and a half. Many HFT strategies trade even more frequently and with much shorter holding periods.
Two things occur when a strategy trades enough to get to the law of large numbers.
The first is that the strategy’s win rate will become less erratic and will start to tend towards its theoretical average, which has to be a positive win rate in the case of successful strategies. Until a strategy gets to the law of large numbers there will be no guarantee it can perform according to its designed win rate. When a strategy’s win rate is only slightly positively skewed, it may risk negative average win rates when it hasn’t traded enough.
The second is compounding effects. We tend to think of compounding occurring on a yearly basis. However, the concept of the law of large numbers accelerates the effects of compounding for these high frequency strategies. Many HFTs transact millions of trades per day2, thus even with an only slightly positive win rate they can compound very small daily profits very quickly into extremely large profits in a year.
It must be highlighted that without the use of technology and super computer processors, high frequency trading will not be possible.
TAKEAWAY 2
The combination of a positive win rate strategy that can get to the law of large numbers, will be a successful and profitable strategy.
Adaptive Trade Size Management
Active Trade Size Management is very different from a fixed trade size approach like being a fixed percentage of your capital. Adaptive trade size management is not discretionary or subjective because the trade size for each trade will be determined by Math. There is a well known technique called the Kelly Criterion which we have a prior article written on it. To illustrate the concept, maybe we can use coin flips as an example.
When flipping coins, the theoretical outcome is 50/50 for both heads and tails right? But actual experience will tell us differently. Anyone trying this out may experience randomness on most parts, but there may also be moments where you get streaks of constant tails or heads.
Thus this is how Active Trade Size management works. It is mathematically designed to exploit these streaks whereby the trade size will increase with each trade when you are on a winning streak. When you are on a losing streak, the trade size will be reduced with each trade. So basically, win more bet more, win less bet less.
TAKEAWAY 3
The science actually proves that when you have a strategy that has a positive win rate, and has traded enough times to get to its theoretical win rate, a win more bet more and lose more bet less approach becomes a profit enhancing machine.
Conclusion
Many aspects of our lives are being disrupted because of technology. We are seeing it happen in the trading world as well. What many are not aware of is that even the way successful trading strategies are now being developed, has dramatically changed compared to the past.
Conventional trading strategies have almost none of these following modern day winning strategy characteristics:
- High win rate strategies are no longer mandatory to be successful, they just need to be slightly positive.
- Successful strategies leverage the use of technology and computer processing to accelerate the effects of compounding profits by trading more frequently, as long as these strategies have a positive win rate.
- Successful strategies even use a mathematical approach to determine trading size. The trade size for every trade is dynamic, with the governing logic being to trade bigger when winning and trade smaller when losing. This approach has proven to enhance strategy returns.
1 Zuckerman, Gregory, The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution, November 5, 2019
2 https://www.investopedia.com/terms/h/high-frequency-trading.asp
