“Keep it simple”” was the advice I received from the Portfolio Managers at Quadrature Capital. At the time I didn’t comprehend what it was exactly that they meant. In this post I explain the meaning I’ve come to understand and the process I go through to keep it simple.
The takeaway message: successful trading isn’t about making clever predictions [1]; it’s about avoiding mistakes and that alone [2]. Adding complexity only increases the number of mistakes it’s possible to make [3].
Before completely disregarding that statement I encourage you to listen carefully to these well-known traders:
- Robert Carver (ex Hedge Fund Manager at AHL, visiting lecturer at Queen Mary University, Economics MSc) – Seven deadly sins of trading – “”I don’t believe that trading and investing in the financial markets requires a huge amount of skill to do reasonably well. It’s mostly avoiding making a series of typical mistakes.”” – Some more trading rules – “”It is a common misconception that the most important thing to have when you’re trading, or investing, systematically is good trading rules. In fact it is much, much, much more important to have a good position management framework (as discussed in my first book) and to trade a diversified set of instruments.””
- Dr Ernie Chan (Managing Member of QTS Capital Management, Theoretical Physics PhD) – Better System Trader Interview – “”Stick to the stuff that generates profit with limited risk. I’ve found those are the strategies that are simple and does not require a fancy mathematical framework to work.”” – The Do’s and Don’ts of Quant Trading – “”A lot of times a successful trading strategy is created through the elimination of bad trades alone.””
- Dr Michael Halls-Moore (CEO of QuantStart, Aeronautical Engineering PhD) – Chat With Traders Interview – “”I tend to stick with some pretty simple stuff … trend-following and mean-reversion type strategies … use pretty straightforward trading signals … not much more complicated than if the signal has diverged dramatically then buy in and if they converge then sell out again … “”
- Dr Jim Simons (Founder of Renaissance Technologies, ex Professor of Mathematics) – Numberphile Interview – “”… [no single strategy] is so overwhelming that you’re going to clean up on any one … there aren’t elaborate equations for the prediction part…””
[1] Simplicity mainly concerns the individual strategies themselves; there’s room for some complexity in how you combine simple strategies together. [2] There are alternative valid approaches with varying levels of complexity but the approach I present is the one I suggest you start with. [3] Cleverness can be used to booster performance but it shouldn’t be relied upon to turn a losing strategy into a winner.
What is Simple
- It should be widely known and/or immediately obvious that the strategy is highly likely to be profitable (subject to certain hedgeable risks). There should be no need for subtle implementation details or finely tuned parameters. Simple means obvious.
- When describing your strategy to an average A-Level student they shouldn’t be impressed by your cleverness. Given a one-minute description of the strategy I should be able to replicate it precisely and in its entirety. Simple means succinct.
- It should be possible to run your trading system with pen, paper and a pocket calculator. Automation with powerful computer servers is just a time-saving exercise. Simple means elementary.
- Ideally the strategy has no free-parameters and maybe a couple of rules. Simple means plain.
- A simple strategy could be to buy-and-hold a large group of assets. Another would be to enter when the price of a combination of dozens of assets falls below some fixed level and exit once it exceeds some level or some period of time has passed. No I’m not oversimplifying; you can literally trade those two strategies profitably. Simple means simple.
What isn’t Simple
To make sure you’ve got the right idea, let me explain what is not simple.
- A grand-unified mathematical framework that governs the dynamics of the markets. Simple doesn’t mean elegant.
- Optimisation of utility functions to determine timing and position sizing at the strategy level. Simple doesn’t mean optimal.
- Finely tuned strategy parameters values that are the only values that work historically. Simple doesn’t mean precise.
- The idea only applies to a single asset or a small collection of assets. Simple doesn’t mean bespoke.
- A strategy with dozens of parameters and rules for determining how to time and size your positions. Simple doesn’t mean all encompassing.
- A cluster of hundreds of computers is necessary to run programs simultaneously for several hours to simulate a backtest. Simple doesn’t mean automated.
- Anything verging on first year undergraduate mathematics. Simple doesn’t mean mathematical.
How to Keep it Simple
At this point you hopefully have an idea of what constituents a simple strategy, though you’re still likely to overcomplicate things regardless.
Here’s a three step cyclical process to converge to simplicity:
Try, fail and give up
You’re not going to get everything right the first time. Your beliefs about how things work are likely wrong. You don’t know what questions to ask. You will solve problems that don’t matter. Your expectations are misguided. You will make mistakes that you didn’t anticipate.
Prove it was destined to fail
Carry out thought experiments using synthetically generated data. Demonstrate that even if you knew the properties of the data with certainty, the approach you’re taking wouldn’t succeed. Figure out what assumptions you’re making. Hint: You’re probably overestimating your ability to accurately predict returns.
Make less mistakes
Once you’ve figured out what assumptions you’re making you need to weaken them. You need to become comfortable with rules-of-thumb and somewhat arbitrary decisions. In financial markets there is too much uncertainty to identify optimal decisions. As a systematic trader you must keep it in the back of your mind that it is possible to succeed without any automation. By sticking to strategies that don’t require automation you will be in the right ball-park in terms of complexity.
Simplify, simplify, simplify. The problem isn’t that you’re not being clever enough. Be less elegant. Be less optimal. Be less precise. Be less bespoke. Be less encompassing. Be less automated. Be less mathematical. To quote Bruce Lee on Trading Martial Arts: “”It is not the daily increase but the daily decrease. Hack away at the unessential.””
As a beginner trader I urge you to stick to the following mantra:
Successful trading isn’t about making clever predictions; it’s about avoiding mistakes and that alone. Adding complexity only increases the number of mistakes it’s possible to make.