28 Oct Do Systems Really Break?
Do Systems Really Break?
Oct. 28, 2020
Last week, I gave away a free trading system.
Because the systems I’m using in my Experiment are not free.
For one, I wouldn’t mind getting paid for my time. I worked a long time on those systems, and it would be nice to get something back for my work.
And, as a wise man once said, “If you’re good at something, never do it for free.”
But the other reason is that I don’t want my systems to be stolen and used in too many accounts by too many people. As the Internet Urban Legend goes, if too many people start using those systems, they’ll stop working.
And I don’t want that.
But is that Urban Legend true? Or is it hogwash regurgitated down through the ages for no provable reason?
In short, do systems really break?
Long Term Capital Management’s(LTCM) system broke. Kind of.
But they dealt in anomalies, not systems. They used a complicated form of arbitrage. The price over here is too cheap and the one over there is too expensive. Surely, they both will revert to the mean. So they went Long the cheap one and Shorted the expensive one and made tiny profits on both.
And then they leveraged those microscopic profits into big profits. Lots and lots of leverage.
Is that a system, though? In one way it is but in another way it’s just hoping that mispriced anomalies continue. And if a lot of firms start doing it, too many people are buying the same cheap instrument. Guess what happens if a lot of people buy the same thing?
It goes up.
If it goes up, it’s not cheap anymore. The anomaly disappears if more people get interested.
Which is pretty much the same thing as saying the system broke.
For LTCM, the time period it took for the system/anomaly to stop working was four years.
Urban Legend fulfilled.
But what about a different system? What about trend following?
Let’s say a firm wants to buy a breakout. That’s the system. And it wants to buy a breakout when price moves to a new high of the past 100 bars.
How would that system break?
First, everyone would see that Firm A is making a ton of money, so vultures start copying Firm A’s system (after stealing the system secrets).
Now new firms everywhere start buying instruments when they reach a new high of the past 100 bars. What happens then?
Does the anomaly go away? Does the system break?
If everyone buys at the new high…price goes up, right?
Isn’t that exactly what Firm A wanted to happen anyway? In this case, the more people that copy the system, the better the system will do.
Or, evil firms could know that Firm A (and others) will be buying at the 100-day breakout. So, the evil firms could start buying BEFORE the new 100-day high, and then start selling when the 100-day breakout occurs.
Now there would be selling pressure at the breakout instead of buying pressure. And the breakout might fail while evil firms have made small profits.
This assumes, of course, that the evil firms could make money on the “pre-breakout”. If the evil ones buy too late, they won’t make a profit on the breakout orders. The scalp is too small. If the evil ones buy too early, it may not make it to the breakout level at all. They may be taking a trade that never would have broken out.
In this circumstance, the evil firms would be taking a loss that Firm A never took in the first place.
Does that seem like a fun way to trade? Does that seem like a profitable way to trade? And how does fading and scalping the breakout make more money than getting a breakout that makes millions?
So the evil firms could compensate and not scalp the breakout, they could just get in early and stay in.
In which case, Firm A is still getting the same trades it’s always gotten.
It seems like a fundamentally-sound trend following system is theoretically unbreakable. Scalpers can’t game it and imitators only help it.
But do we have any real evidence that trend following systems don’t break?
We do. Trend following firms like Dunn Capital Management have literally been trading breakouts since the 1970s. And that’s typical. Many firms have been using breakouts since the 80s and 90s.
LTCM blew up in four years. These firms have seen the same performance for several decades.
Maybe some systems don’t break. Maybe it’s only the systems that look to scalp tiny profits that break.
Maybe there’s nothing to worry about.
In our next newsletter, we’ll go over the free system again. We’ll see if it’s a system that’s breakable.
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