Why Do Trading Strategies Stop Working?

Trading Strategies – Typically, new traders devote their whole time to finding the ideal trading approach. They believe that once they locate it, their trading career will be complete.

The truth, though, is quite different. Trading tactics need to be changed when they stop working.

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Why Do Trading Strategies Work?

Trading strategies work because they manage to detect repetitive market behavior. Repetitive patterns can be anything, but in most cases they are based on technical analysis. For example, a really simple trading strategy might be to buy after the market has made three consecutive lower closes and sell a day later. A trading strategy doesn’t have to be much more complicated!

Trading strategies are advantages, but based on the definition, it can be said that a trading strategy is superior. A solid trading strategy has been verified through rigorous reliability tests and has a good chance of continuing to be profitable even after it has been developed.

How Do You Know If A Strategy Has Stopped Working?

Let’s say you have created a strategy that has passed the test of strength, and started trading on it. What would you do if the strategy crashed right after you launched it?

Well, many traders would panic and close it immediately.

However, those with a little more experience know that drawdowns are a natural part of trading. They happen from time to time, sometimes so small that they go unnoticed, and sometimes so big that you can doubt your strategy.

Unfortunately, it is impossible to know with 100% certainty. As soon as the strategy goes into a drawdown, this may very well be the beginning of the end or just another drop in the curve. You cannot know!

Therefore, you need to set a stop loss at the strategy level. When a strategy hits a stop loss, it simply stops trading! The strategy may work again, in which case you should wait to make sure the rise is not temporary!

Why Strategies Don’t Work?

To better understand why a trading strategy doesn’t work (or possibly stops working), you essential to understand why trading strategies fail:

• Backtesting is not long enough and there is no out-of-sample test
• Backtesting must generate many trades to be meaningful. In addition, it must be of considerable length. Many traders only use short time frames and are therefore more prone to randomness and cyclical market trends.
• Simply put, most trading strategies are not properly supported. Some strategies work great for several years before they disappear. Breakouts can work in a bull market, but less so in a bear and sideways market. Be sure to test in all kinds of markets.

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1.      Trading Strategies Stop Working Due to Curve Fitting

When something fits the curve, it’s only a matter of time before it becomes useless. Curve fitting occurs due to too many parameters and criteria and too short a period of time to backtest.

2.      Structural changes make business strategies obsolete and stop working

We have had great success for several years trading opening imbalances at the NYSE open. But all decent things come to an end, and the transition to e-commerce has made the dedicated system almost obsolete. So our best strategies just stopped working.

The way stock markets work has a huge impact on how strategies work (or don’t work). Legislation and influence have great influence.

3.      Cyclical changes make it difficult to trade and follow trading strategies.

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 poor performance before getting back on track. This makes them very difficult to track and trade, which is perhaps why they seem to work in the long run.

Dogs of Doe was once a very good strategy, but in the last ten years it has gotten worse. Is it a cyclical or structural change? Permanent or temporary? We don’t know, but the markets have evolved and changed since this strategy became very popular.

For example, Ben Bernanke initiated quantitative easing and it had a huge impact on asset prices and behavior. Is it permanent or temporary? We don’t know, but it definitely changed the market!

4.      Be dependent on one type of strategy.

Some only trade mean reversion while others trade only trend. Similarly, some of them are day traders and some are swing traders.

We believe that this is the mistake of many novice traders. You have to be agnostic and change everything that works.

A dollar made from crude oil equals a dollar made from Microsoft intraday trading. Trading the dollar during the day is similar to trading the dollar on a weekly timeframe. We believe that the most rational approach is to diversify into different timeframes. Why? Because not all timeframes go down at the same time.

5.      Strategies Don’t Work Due To Survival Bias

This is something that all traders ignore (or forget). They tend to “forget” because the survival bias is supposed to be just a minor issue, a detail?

No, unfortunately the survival bias can go a long way. We covered this in a separate article that we highly recommend reading:

Behavioral errors cause you to not follow strategy signals, so you don’t have a strategy.

The first requirement for a trading strategy is that you must trade all the signals that the strategy tells you to take. But business biases always get in the way of the process. It’s easy to miss a trade after four losses in a row or if you find yourself in a dip!

But what this really means is that you don’t have a strategy at all if you miss trades. Before trading a signal, it is almost impossible to know whether it will be a win or a loser. Markets are unpredictable and generally not intuitive. You have not tested missed trades and therefore do not have a strategy. Many quants become discretionary traders by skipping trades.

6.      Commissions And Slippage Are Lowered

Due to structural changes such as those described above, slippage can increase or decrease depending on certain factors. For intraday traders, this can be the difference between a lot and nothing.

·       Inefficiency Eliminated

Eventually, all inefficiencies in the markets are eliminated. 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 remember that short-term trading is a zero-sum game. If you are participating for the long term, you get the momentum from the gradual increase in prices (inflation) and rising profits. This takes time to reflect on rising stock prices, but traders don’t have that luxury.

The options and futures markets are 100% zero-sum markets, even with negative costs. What are you doing, someone else has to lose.

Conclusion

Strategies stop working because the market is changing or because they were on a curve when they were developed. However, no trading strategy lasts forever, and therefore it is important to take preventive measures to ensure that you can withstand the failure of one or even several trading strategies without being destroyed.

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