System Trading - Part 1: A Brief Background

I have been contemplating jotting down all I know about system trading at a common place but never got around to doing so. So maybe in a series of posts I will try to delve into whatever I have learnt about mechanical trading over the years. Though currently I do not use this in my core portfolio there are elements of this I leverage for instance the way I do money management is directly from these methods.

But first a disclaimer: Again this is a purely theoretical exercise and please do not take it as some form of financial advice. If you do so the risk and returns associated with it are totally yours. 

Before you read on do spare a thought on Why do you invest? After thinking it over write it down.

Investing or Trading is an endeavor with one sole goal that is to make maximum money with the least chance of going bust

It is not an endeavor to be proven right. If that is the reason better to take up Economics. Have you even found an economist who thinks he or she was wrong? I haven't found one yet. Let me know if you do so. Anyways let us move on.

Background

I had some understanding of financial markets before I actually put a single rupee into it as I had an MBA in Finance where I really enjoyed subjects like Derivatives and did not like subjects like Corporate Valuation. Why that was so perhaps because in derivatives everything was black and white, more mathematical whereas in valuations it was partly mathematical but more an art. A piece of art can be viewed very differently by every other person. I do believe in valuations though but they are not be all and end all in my books.

I started putting my own money in the market around June 2010 just after my first salary. At that time I thought of only index futures trading. I was obsessed with it. I thought it was an enigma which needed to be cracked. But only after 2-3 years of tinkering with my systems I realized it was a fool's errand. And then I came across a guy called Ed Seykota. He sums it up beautifully about system trading.

Systems don't need to be changed. The trick is for a trader to develop a system with which he is compatible.

What is a System in Trading

A System in Trading or Investing is a method which defines 5 set firm rules:

1. Choosing a security
2. Entering a position
3. Position size
4. Exiting the position

Rinse and repeat with any feedback loop. That is all there is to it. The key words are set firm rules. Some examples now.

Example 1: SIPs done by retail investors in active or passive funds

Instrument: HDFC Top 100 or UTI Nifty Index

Buy signal: Date in this case 5th of every month

Position size: Fixed at Rs 10,000

Sell signal: 10 years from day of start

Example 2: Growth large cap stock picker

Instrument: Equities with 10% QoQ operating revenue growth, low debt to equity ratio, ROCE above 20%, free cash flow is greater than weighted average cost of capital, a subjective conclusion on the quality of management

Buy signal: At the moment such a stock is discovered

Position size: A percentage of portfolio depending in the confidence in the analysis above

Sell signal: When growth in operating revenues falls below 10% or ROCE is below 20% or WACC exceeds FCF

Example 3: Small cap value investor

Instrument: Business with less than 5000 Crs market capitalization. The scuttlebutt says that the company is about to expand operating margin or is about to enter into a long term contract with a major customer as the sole supplier for the products it manufactures 

Buy signal: At the moment such a stock via scuttlebutt is discovered and the fair value estimate is below the market price of that stock

Position size: A percentage of portfolio depending on the confidence in the analysis above

Sell signal: When the market price is clearly above the intrinsic value of the business meaning the stock is clearly overvalued

Example 4: Technical Trader

Instrument: Any equity which is liquid beyond a defined threshold on NSE

Buy signal: The stock price hits a strong support line at any of the given Fibonacci retracements

Position size: As a fixed percentage of portfolio

Sell signal: The stock price hits a resistance line or hits a fixed trailing stop loss of 10%

Example 5: Mechanical Trading System

Instrument: Any stock which clears the screen of an uptrending filter meaning the stock price is making higher highs and higher lows in a given time frame

Buy signal: When the fast moving average of 30 day price crosses over the slow 60 day moving average

Position size: A percentage of capital basis a combination of historical probability of winning with this system and the payoff ratio of each trade (payoff is the ratio of the average winning trade divided by the average losing trade)

Sell signal: When there is a drawdown in the trade or when the slow moving average crosses the fast moving average or the stock price goes from an uptrend to a sideways trend

Now unfortunately only the instance in Example 5 is assumed to be system trading. All these methods have their own pros and cons. But that is for another time. I wanted to delve only on the type in example 5 i.e. Mechanical System Trading.

A small philosophical note. There are as many ways to make or lose money in the capital markets as there are the number of stocks listed in the market. No method is the holy grail and no method should be placed on a higher pedestal. It is about practicing your art. It is always about learning and being a student of the art you love. Yes one has to love and have passion to know more else it was just a small fling to start with. One advice is it to read a book called Zen in the Art of Archery by Eugen Herrigel.

In the subsequent posts on the topic of System Trading I will share one system and go through real life trades which I have done for 3 years. I maintain a very small part of my portfolio in a purely mechanical system. I do this just because I enjoy to do so. The topics I will cover will be.

• Consideration Set: How to chose an instrument? Which instruments will I have in my trading universe. I cannot have all equities in it or trade only futures. They need to pass a certain threshold to enter this list.
• System Definition: What will be the underlying principle of this mechanical system? I will consider long only - equities asset class based system.
• Entry Signals: When to enter a trade? I will pick when to enter a long trade. Define the stop loss or equivalent risk containment measures.
• Trade Management: How much money to bet on a trade? Given the historical results of this system I will decide how much portion of the mechanical portfolio should I bet on this trade.
• Exit Signals: When to close a position? I will define the rules related to profit booking or containing drawdowns in case the trade does not go as planned.
• Results Evaluation & Feedback Loop: How will I evaluate my trade? I will look at how the trade performed against returns and drawdowns. I will incorporate expenses by the way of brokerage, taxes and any dividends lost. I will note down any key takeaways from the system for future trades in a journal.
• Emotional Management: How to stick to a plan and not tinker with it.