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The Holy Grail

However, although there is certainly non-random behaviour in the financial markets, equally there is almost certainly no ‘Holy Grail’ or ‘secret formula’, that even the most successful quantitative funds have discovered.  If that were the case, there would be no need for them to trade so many instruments, over so many time frames, with many different models, and to focus so much of their resources on efficient execution (which will be covered in a later article).

After many failed attempts, when the author finally began to post some very consistent returns, over a two year period, a good friend inquired what his secret was and what he had discovered.  He replied that he hadn’t found any secret to the markets, discovered anything new, nor stumbled upon any ‘Holy Grail’.  He had just identified a few small, robust, edges, which were traded across as many crosses as possible, to which the very astute response came, ‘That is the Holy Grail’.

Understanding the Odds

A casino only has a small edge on any given spin of the roulette wheel and will lose many times in a night, and indeed many times in a row, but statistically, it will win overall, over time:

e.g. A roulette wheel typically has 38 slots with 2 zeros.  This gives the house an edge of 2/38 x 100 = 5.26%, when players bet on red or black.  Even such a relatively small edge produces a substantial and incredibly consistent revenue stream for the casinos and their shareholders.  The more times the wheel is spun and the more bets are made, the more the casinos probability of winning tends to 100%.

This is exactly what the systematic trader should be seeking to achieve – identifying and exploiting a small edge, as many times as possible; being the casino.  Therefore, the first step in developing a robust system has to be identifying an edge.  To do this, the main tools of any system developer are good historical data and software with which to analyse it.  There are a number of excellent sources of data and software, readily available now.  This is a huge advantage, compared to even relatively recent years, when it was very hard to come by, particularly for foreign exchange data, with no central exchange, the dominance of voice brokers and a very fragmented market.  The rapid increase in computing processor speed is also a huge advantage.

Once we have those tools in place, the next task is to quantify trading ideas and this is where any system developer will soon be able to relate to the famous Thomas Edison, inventor of the light bulb, who famously said,

‘I would construct a theory and work on its lines until I found it was untenable. Then it would be discarded at once and another theory evolved. This was the only possible way for me to work out the problem... I speak without exaggeration when I say that I have constructed 3,000 different theories in connection with the electric light, each one of them reasonable and apparently likely to be true. Yet only in two cases did my experiments prove the truth of my theory.’

Successful Trading Systems

Unlike Edison, we have the advantage of knowing that profitable trading systems can be developed, as there are a number of proven systems already in existence, which one can easily test, such as the ‘Channel Break Out’ (CBO) system, made famous by the ‘Turtle Experiment’, where Richard Dennis and William Eckhardt had a wager about whether successful trading could be taught (and proved that it could).  Those same channel break out/trend following, techniques have been exploited by many successful funds.  The ‘Opening Range Break Out’ (ORB) is another system, which has been proven to have a consistent edge, perhaps most famously exploited by Toby Crabel.

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