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The Goal in Systematic Trading

The goal in systematic trading (and in life in general), is to minimize the gap between what we want to achieve and what we actually accomplish.  What is systematic trading?  It is the adherence to a set of predefined rules for entry, exit and risk management (such as position sizing, correlations, and so on).  With the ability to upload these rules to your broker’s trading platform, theoretically, there should be no gap between what you want your system to do and what it actually accomplishes.  Yet, that gap persists.

The gap usually occurs when emotions run high.  Traders override their automated rules, pausing or even abandoning their trading models entirely. A classic example of this occurred during the 2008-2009 Financial Crisis, when a significant number of systematic traders halted or altered their automated models, citing the instability of the financial system (e.g. systemic risk) as well as unprecedented levels of volatility as reasons for dialing back risk exposures.  While the decision to do so might have seemed prudent at the time, the issue for me as a trainer of traders and risk managers, is that these traders created a gap between their model’s expected performance and the results achieved.  Essentially, this was a breakdown in discipline, and it’s this psychological gap that I want to examine in this article.

Why do these gaps occur?  While the specific reasons can vary, the core issue is usually the same: emotions run high and traders override their models. Once this happens, they risk losing their edge in the market because they’re letting emotions drive their decisions, instead of sticking to the positive expectancy models that they’ve developed.

The alternative is to stay disciplined and follow the model, even when it feels uncomfortable.  If we’ve rigorously backtested our system, we have a solid understanding of what future performance could look like (assuming market conditions are somewhat similar to what we’ve seen in the past).  Deviating from or abandoning the model means we lose the data-driven support for our decision-making process and that we risk devolving into reckless decision-making processes (aka, gambling).  Given the choice between the discomfort of sticking to the model or the chaos of reckless gambling, I’ll embrace the emotional pain, maintain my discipline and eliminate the gap every time.

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