The Benefits of Strategy Trading

The Benefits of Strategy Trading

I believe that a trading strategy, which has been properly developed and tested,

can make you more money than trading any other way. However, this is not the

only reason that strategy trading is the method of choice for most successful

traders. There are other benefits as well. One of the most important benefits is

that you can sleep well at night knowing that you’re trading a strategy that has

been tested and re-tested, and is proven to be successful. No matter what happens

in the market during the day, the confidence you have in your strategy makes this

type of trading easier on you.

Another advantage is that you can choose a market and a trading strategy that

compliments your personality. The basic idea is that the trading strategy you select

is based on the type of market action you are the most comfortable trading.

Those who desire to always be in the market will select a different strategy than

people who prefer short-term positions. If you get a thrill out of riding the big

trends, then you will select a different type of strategy than someone who enjoys

going against the trend.

Have you ever received an unexpected call like this, “Hi, Joe. This is Stan, your

broker. We need to settle the margin on your account. Looks like the market

really went against you this week”?

If you are a strategy trader, this is not likely to occur. Strategy traders always know

where they stand financially. They know this from the financial results of the

historical tests. If you do get a call like this, you will most likely be expecting it and will have planned for it. You have creatively designed a strategy based on the amount of money you have to work with. As a part of knowing the maximum

equity drawdown associated with your strategy, you can determine the strategy’s

capital requirements and make adequate provisions to provide enough capital to

maneuver through the eventual drawdown. There will be no financial surprises.

I’ve been talking at length about why strategy trading is the most viable way to

make money in the markets and what type of skills and knowledge are necessary

to be a successful strategy trader. I showed you a study that in my view gives very

solid proof that strategy trading (objective decision making) is the most successful

way to make decisions. If there was ever any doubt in my mind, this study cleared

it up. I hope you are now convinced that if you want to make money you should

be a strategy trader.

OBJECTIVE LINEAR MODEL (STRATEGY TRADER)

OBJECTIVE LINEAR MODEL (STRATEGY TRADER)

For the Objective Linear Model, the researcher developed an objective model

based on historical tests and observations to predict results. This is defining and

using quantifiable data, running historical tests, and then using the results of the

tests to predict future outcomes.

For instance, the researcher would look at reams of physical data from cancer

patients, and correlate the data with how long the patient lived. After running the

historical tests, the researcher would then obtain the physical data from a cancer

patient, and using the historical test data, attempt to predict how long that cancer

patient will live.

This is exactly what a strategy trader does. He runs historical tests and then uses

that data to take a position in the market. He uses objective, quantifiable data

tested historically to make his trading decisions. Table 1 shows the results of the

tests.

SUBJECTIVE LINEAR MODEL (TECHNICAL TRADER)

SUBJECTIVE LINEAR MODEL (TECHNICAL TRADER)

A Subjective Linear Model is a much more complex decision making process. It

starts with interviewing experts in a field and learning how they make decisions.

The researcher literally asks the expert how he or she makes decisions and they

respond by explaining how they make their predictions. Although these experts

are not using quantifiable data, they have enough experience and knowledge in

their field to be successful. This decision making process is then outlined by the

researcher.

For instance, a physician, highly experienced in treating cancer, probably has

become fairly adept at predicting the life expectancy of his patients, even without

using any objective data. The researcher interviewed the physician and attempted

to determine exactly how the physician made this assessment. Then the researcher

put this newly quantified data into a regression model and attempted to predict

the life expectancy of cancer patients.

This is very similar to how our technical trader makes decisions. He goes to

seminars and reads books to learn how the experts make decisions using technical

indicators. He then takes what he learns and attempts to trade like the experts. In

a sense, he does his own regression model of the expert’s process to make trading

decisions.

INTUITIVE PREDICTION MODEL (DISCRETIONARY TRADER)

INTUITIVE PREDICTION MODEL (DISCRETIONARY TRADER)

Intuitive prediction is defined as making a decision without the use of any

objective or quantifiable data. For instance, in trying to predict the academic

performance of graduate students, the researches asked their advisors to do so

without seeing their grades and just by talking to them. The decision-makers had

to rely on their intuitive impressions and any other factors they thought relevant

(how the students dressed, their language skills, grooming habits, etc.).

This is the same way our discretionary trader makes trading decisions—using

intuition and gut instinct. Although he might think he does, he does not use any

objective criteria. In predicting the stock prices, it is highly likely that the

researcher engaged a discretionary trader to predict the future prices of stocks.

Decision Models

Decision Models

I have always been interested in the science of how we as human beings make

decisions. Life is really all about making decisions. If we can improve the way in

which we make decisions, it stands to reason that we will be more successful in

life. If we can improve the manner in which we make our trading decisions, we

will become a more effective trader and hopefully make more money.

In my early years of trading, I always wondered whether there was statistical proof

that strategy trading was inherently more profitable than other types of trading. I

knew from my own experience that it was but I was unable to prove it statistically.

I then picked up a book called Decision Traps. This is a book about the process

3 of decision-making and I picked it off the bookstore shelf when I was attempting

to learn how to become better at trading. I didn’t know at the time that it would

put forth the notion that objective decisions (i.e., strategy trading) produce far

superior results than other non-objective forms of decision making.

In this book, nine different types of decisions were tested using each of the three

different decision methods. The accuracy of the decisions was then compared and

analyzed for effectiveness in predicting final outcomes. The investigator looked at

different types of decisions, predicting grades, predicting recovery from cancer,

performance of life insurance salesmen, as well as predicting changes in stock

prices. He used three different decision making processes: an Intuitive Prediction

Model, a Subjective Linear Model, and an Objective Linear Model. Interestingly

enough, these can be compared to our 3 types of traders: discretionary, technical

and strategy.