Trading room – Monday 19 Nov 2018
Most traders are always looking for the trading system that can give them the best trade signals to act and make money in the market. Let’s define a trade signal first.
A trading signal is a trigger for action, either to buy or sell a security or other asset in the market and generated by an analysis. This analysis can be generated by using fundamental analysis, technical indicators (which can be quantitative or qualitative) or it can be generated using simple or complex mathematical algorithms.
The signals can be based on direct market conditions (for example the price or volume movement of a stock) or non-direct market factors such as the company or economic indicators.
Hence, one could use many discipline inputs into formulating one’s trade signal.
However, when we are trading actively in the market, where entry and exit are likely to be more frequent, we would be more focused on shorter-term trading signals as they would be more dynamic and adaptive. That said, a longer-term technical term based on a bigger timeframe analysis could still be used to complement a buy-and-hold strategy or even used on its own merit.
To formulate a trading signal which is dynamic and adaptive, we have to use technical signals which react very quickly to the security asset price movement. After all, we are trying to make a profit from the changes in the price of the security.
There is no limit to how complex a trade signal can be. Some traders would want to keep things simple by using only a handful of inputs.
There are obviously a few advantages to using a simple trade signal as they are easy to understand for a trader and obviously, for practical purposes, it is far easier to manage a simple signal generator and periodically test it to see what components need adjusting or replacing.
Hence, we have a lot of analysts and traders advocating simple stand-alone trading signals such as using a moving average crossover, price patterns on a chart or easy mathematical ratio calculation such as a Fibonacci retracement, etc. among many others.
However, simple stand-alone trading signals have their drawbacks and limitations and many traders wishing to grow their trading depth and breadth are hampered by them.
Increasingly, elite traders are using more accuracy, flexibility, and adaptability of more complicated trade signals to match the complexities of their portfolio or to trade in a more volatile market condition in today’s trading world.
Such signals would involve the assessment of the risk and reward of the signal as well as its relation to the market condition or other securities in the market, among others and could be matched with other types of analysis such as fundamental analysis.
The question is should a trader rely on simple stand-alone trade signals or one that is more complex and generated by say a trading algorithm?
The answer likely lies in the way a trader would want to trade in the market.
Let’s look at simple trading signals such as a moving average (MA) or relative strength index (RSI) indicator which are commonly used in the market.
The main pitfall of using simple trading signals is that typically on back-testing the signal, one would find that it works roughly 50% of the time most of the time (which typically replicates the law of averages). This is especially so if the indicator is used without any tweaking of its parameters and without regard to the prevailing market or peer conditions.
This means on the average, a trader will get one trade right out of two or five out of ten for example. Hence, you can for example spend more time and effort reading 10 research report recommendations based on such stand-alone trade signals and do ten trades and you would still get the same hit (win) rate of 50% than if you were to spend time reading just two research reports and do two trades (assuming both use the same signal mechanism).
And any automated trading signal software on the same signal mechanism would just give you the same result obviously (before you spend big money buying them on their promises).
It may not matter which stock or market you trade as the signal would still give you only a 50% hit (win) rate on average. Sure, on some days, you may get a higher win rate but these would be negated on other days on the downside of the system as the law of averages would bring you back to the average.
Now, obviously, many elite traders can (not common traders) still make a lot of money on a 50% trade probability by increasing their gains on each winning trade and cutting the losses short on each losing trade.
This is a perfectly acceptable strategy and your success then much would depend on your trading plan and money management strategy in the trade.
But for a lot of common traders, it is hard to trade on a 50% hit rate due to human nature and emotions such as confidence, greed and fear, and trade factors such as accuracy and timeliness of the signal itself.
But this would be the subject of an entirely different topic altogether.
To improve the odds, one should thus try to raise the hit (win) rate to as high as possible above 50% while at the same time still managing the win gain/loss amount on each trade.
These would raise the overall success rate of the trader and the gain in the total equity of the overall trading system.
To improve your hit rate, it is not likely that you can just rely on a stand-alone simple trading signal since if everybody is using it, how would that make you stand out from the average crowd of average traders and give you a trading edge in the market?
Don’t get us wrong, however. Many simple trading signals are still excellent to use but as highlighted above, with the odds at 50:50, most traders are not able to handle the money management of the trade or handle them poorly that they lose money overall in their entire trading profit and loss account.
And even if you handle them correctly, you are not likely to be optimizing your capital as you may not be picking the best opportunity in the market.
For example, a moving average convergence divergence (MACD) trade signal would give exactly the same signal for two stocks but will not tell you in advance which stock is likely to move more or give you a bigger bang for your capital.
To gain a better hit (win) rate, you either may have to tweak the simple trading signal to suit the market condition or use it in combination with some other collaborative signals.
But not all trade signals are equal in strength as well as a trend following signal, for example, will not be suitable for certain types of stock price behavior or market condition.
Most trading signals also contradict each other where you have a trader putting 10 indicators on a chart without understanding how each indicator is derived mathematically and work with each other.
In addition, a trader will not maximize his chances of winning on a trade or create an optimal portfolio of stocks without understanding the macro picture such as the sector or market condition where position sizing and overall exposure of the trade or portfolio would be as crucial as picking the right trades to enter.
For example, an asset allocation strategy (top-down approach) may work better than a stock picking strategy (bottom-up approach) for a stock portfolio in different market conditions.
Further, simply using a stand-alone trade signal without understanding other aspects of a stock such as its sectorial/thematic play or its basic fundamentals could also undermine one’s trade profitability if not making it fatal to the overall trading plan.
Many vendors are also selling their automated trading system which typically relies on simple trade signals (although they will tell you it’s not so in various marketing jargons) and promise that you would be very successful without any human or trader input.
Such automated systems would not only have all the drawbacks and limitations mentioned in the preceding few paragraphs above but worst, you may never ever know where you went wrong in the trade and learn to become a better trader.
As they say, if you have to lose big money in the market, at least know why you lost it.
Furthermore, we believe that a trader should network and talk to fellow elite and master traders to learn the best of their trading skills and experience (and not network and talk to machines to learn).
If you are a trader who uses simple trading signals, you still can be a successful trader by understanding its limitations and drawbacks. And if such system lifts your boat….
However, the world of trading and its technologies have changed substantially from the past.
The best of the best traders and hedge funds in the world today are increasingly relying on trading signals which are generated by complex trading algorithms to preserve their trading edge against the rest in the marketplace.
There are many reasons why algorithm trading is superior over simple trading signals. Download this extensive report to learn how algorithm trading and big data analytics may be able to supercharge your trading profits in the market.
The global and coming future trend for trading and investment houses are to employ mega-salaried data scientists, or “quants,” who program ultra-sophisticated algorithms and even self-correcting artificial intelligence (AI) statistical models to predict market trends and pinpoint particular trades.
And this is not your common trading platform charting system.
We are talking cutting-edge, state-of-the-art, multi-million-dollar programs that utilize the latest in technological programming to analyze and make sense of millions and billions of bytes of data in seconds to consistently help their traders and investors be ahead of the market.
And you need the same tools and analysis to beat these new breeds of traders and the smart money in the market.
At Malacca Securities Quantitative Trading and Analytics Division, we strongly believe that big data analytics and algorithm trading is the future of trading for the crème de la crème traders and institutional funds in the market.