How to Identify Algorithmic Trading Strategies

In the previous section we had set up a strategy pipeline that allowed us to reject certain strategies based on our own personal rejection criteria.

Ultimately, I believe the best designed portfolios will have allocation to as many diverse equity streams as possible and this is best achieved by participating in as many asset classes as possible. However, once accuracy and cleanliness are included and statistical biases removed, the data can become expensive. 

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Algorithmic Trading Strategies 

In this article I want to introduce you to the methods by which I myself identify profitable algorithmic trading strategies. Our goal today is to .

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Please try again later. Risk Management When formulating a trading strategy, make sure to give thought how much you have at risk at all times. Measure and track your total open risk at all times by calculating how much you would lose should all of your positions be stopped out. You can do this by measuring and adjusting risk by position and your overall portfolio. This means you know how much money you will lose, by percentage of your total account equity, if all of your trades were stopped out.

The example strategy uses a trailing stop based on the lowest price of the last X periods on time period Y. In slow-moving and sideways markets, the stop will move closer to the price and risk is reduced as time goes on.

In parabolic moves in your favor, the price and your open risk will move much faster than your trailing stop. Your open risk on the trade can move from. Without a mechanism to reduce risk further on this trade, you can experience significant drawdowns in your equity and psyche if the trade quickly retraces all of its gains.

Especially when you have multiple trades on all benefitting from the same move. For algo traders, this discovery means we need to have an algorithm to account for open risk on each position and your overall portfolio risk.

How could we do this? Well, you could add in an algorithm designed specifically for these circumstances that could either move stops or reduce positions when risk exceeds a certain threshold and then optimize these parameters in backtesting. Image created using Trading Blox software I learned about this the hard way when I was long oil in I used a very long term lagging indicator as my exit.

My strategy was reliable most of the time in slow, volatile but trending markets. Yet at the same time, the faster it went up, the more worried I got looking at how far away my stops were. I remember hoping that it would consolidate to give my stops some time to catch up. Market Selection Equities Initially, I wanted to apply an algorithmic approach to trading equities, specifically buying stocks at all-time highs, but I ran into a couple of road blocks.

The universe of just US stocks to analyze and back-test a strategy on, including those that were delisted to account for survivorship bias, was around 25, In short, the number of positions needed to buy stocks at all-time highs was much higher than I imagined and the returns of the strategy, while impressive at In some years, close to 2, stocks are making new all-time highs. In order to achieve higher returns, you would need to have a more concentrated portfolio of stocks making all-time highs.

The challenge as I saw it was that there was no way to predict the next Apple, so in order NOT to miss the next Apple, you would need to be positioned in every stock making all-time highs. Based on what I had seen from other money managers, I believed I could achieve higher returns and better risk adjusted returns in the futures market due to leverage and diversification.

Starting Capital — Many futures contracts can move thousands of dollars in one day alone. Imagine trading 20 — 60 markets at the same time.

Rolling Contracts — In the futures market, you trade various contract months that will all eventually expire. When the contract month you are trading expires, you must roll your position to the next contract month if you want to continue carrying your position or avoid taking delivery of the underlying commodity. There are many different options to consider on what triggers to use to roll your contract to the next month. Most traders just roll to the nearest front month contract, the next contract to expire, but this may not be the best approach for commodities, like wheat for example, where each contract month has different supply and demand realities due to the growing season.

Most importantly, the historical data provider I used at the time did not provide any intra-day spot FX data from any FX brokers. Please note that trading Forex and CFDs on margin carries a high level of risk and may not be suitable for all investors as losses can exceed deposited funds.

Both offer very small trade sizes which allow for conservative risk management and greater diversification opportunities for small accounts. Ease of Diversification Traders can also benefit from the diversification available from a relatively small universe of markets opposed to the stock market where the US market alone has close to 25, stocks to consider in your research.

Trading FX and CFDs also gives traders the added benefit of being able to go short without the hassles you would encounter in the stock market. Being able to go short in your strategy adds another element of diversification to your approach.

If the owner of the stock you borrowed to sell short calls them back, you are forced to cover your short position. Determining this ahead of time is not possible. In a Bloomberg interview , he discussed a principle that he calls the holy grail of investing. Meaning you would get 5 times the return for the same amount of risk. However, if you diversify across a thousand return streams with a. If you want to implement leverage in your strategy, you must borrow funds and pay a corresponding interest rate when trading equities.

In FX and Futures, margin is treated as a good faith deposit and does not require any interest payments. Leverage is a double edged sword as it can increase losses as well as profits. Ultimately, I believe the best designed portfolios will have allocation to as many diverse equity streams as possible and this is best achieved by participating in as many asset classes as possible.

Benefits of Adopting an Algorithmic Strategy Risk Management Before implementing a systematic approach in my trading, I had no formal risk management plan.

My algorithmic strategy risked a fixed fraction of my equity on each new trade. If I lost that amount, I would close the trade and wait for the next signal. Logic for trailing stops, profit taking and portfolio level risk management were implemented as well.

Position Sizing For each market I traded, I utilized a multiple of recent volatility using the ATR average true range to size my positions and determine initial stop placement. Smaller positions were taken in markets with higher volatility and wider stops were used. Taking smaller positions in volatile markets allowed me to balance risk across my portfolio based on each markets unique volatility. Wider stop placement gave the position a better chance of not being whip-sawed compared to an approach of using a fixed stop distance across all markets, regardless of volatility.

Diversification Proper position sizing allowed me to take advantage of diversifying across many different markets. When I started out, I took very concentrated positions and experienced a great deal of volatility in my account and emotions. Backtesting Being able to define, clearly, everything you do in your trading system lets you back-test and optimize your trading parameters across your portfolio.

A good back-testing engine allows you to examine how your system would handle every available historical scenario and review each and every trade on a chart. Another feature I would say is a must is the ability to do portfolio level back-tests on multiple instruments at the same time. A thoroughly back-tested system can give you the confidence you need to stick to the system during the inevitable drawdowns you will experience when trading live.

If left to just your judgement when trading, your emotions may drive your decision making with sub-optimal results. Freedom Implementing an algorithmic trading strategy gave me freedom in my day. My mechanical trading system required about 10 minutes of my time per day to trade over 60 different markets. Before, I would be glued to my computer and TV screen all day when the markets were open watching price action and researching trade ideas when the markets were closed.

Many seek out trading for the freedom it can give them in life and then sit in front of their computer day and night looking at charts and news. I can't guarantee that you will be successful, but it's my belief that an algorithmic approach gives people a better chance for success.

Even more important than that, an algorithmic trading approach can improve the quality of your life by giving you the freedom that most seek from trading in the first place. DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.


Trading Strategies Headlines 

Learn more about algorithmic trading in forex markets, which automates certain processes and reduces the hours needed to conduct transactions.

Learn from my experience as a software developer creating Forex algorithmic trading strategies and more in this algorithmic trading tutorial. 7 Essentials for Developing an Algorithmic Trading It’s one thing to have a great idea for a trading strategy and then The basics of forex trading and how. 

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Read about all of the mistakes I made and knowledge gained on my path to creating an algo strategy. In this article I want to introduce you to the methods by which I myself identify profitable algorithmic trading strategies. Our goal today is to .

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