What are model-driven trading strategies and why might they be the way to go for short term traders in 2011 and beyond?
Model-driven trading is about having a specific trading plan, a specific set of trading strategies, and relying on those trading strategies to produce more winning trades than losing trades over a period of time. Model-driven traders may be fundamentally or technically oriented. What is unique about this approach to trading is that it is rules-based.
The opposite of model-driven trading is discretionary trading. Discretionary traders are not without their own rules for spotting opportunities in the market. But those rules tend to be flexible, some times very flexible – and more often than not are more a set of principles than a true blueprint or guide.
Deciding which approach to trading is best for you can be tricky. The idea of casually taking a trade every now and then – a popular stereotype of discretionary trading – may seem like the perfect approach for a part-time or retail trader. But we have discovered a number of features about model-driven trading strategies that may provide significant advantages for the average end of day trader.
Less Stress, Less Work
With model-driven trading, traders are able to focus their decision-making on following the rules and custodial issues related to risk management. Unlike the discretionary trader who may be receiving a large number of conflicting inputs to be decided upon, the model-driven trader needs simply to follow the rules of his or her trading strategies and systems. As Larry Connors, CEO and founder of TradingMarkets puts it, this is “see the trade, take the trade” trading.
While trading is never a simple walk in the park, being able to rely on a set of backtested trading rules can help relieve much of the stress that can accompany active trading. By following a set of rules when trading, the model-driven trader is much less likely to be swayed by the “news of the day” or to second-guess his or her individual trading decisions.
In this way, model-driven trading also tends to require a lot less work. This is especially important for the trader whose trading day begins after the close or in the evening several hours before the market opens. Even those model-driven traders who do not use automated or mechanical trading systems benefit from a trading strategy that is based on merely following a specific set of trading rules. Compare this to a process that requires extensive research and analysis before every single trade and consider which approach might actually better accommodate the busy life of the average trader.
Can traders using model-driven trading strategies make more money than the average trader using discretionary methods? There are many factors involved, but addition to those mentioned above – less stress and less work – that can contribute toward more profitable trading (less room for trader error), model-driven trading strategies tend to be backtested and quantified. And while past results provide no guarantee of future performance, traders who rely on quantified trading systems can trade with a sort of positive expectation that many discretionary traders cannot have.
In fact, a large number of very successful money managers are model-driven traders: from James Simons of Renaissance Technologies Corporation (called the “world’s smartest billionaire” by the Financial Times in 2006) to David Shaw (“King Quant”) of D.E. Shaw & Company.
Importantly, rules-based, model-driven trading strategies need not be especially complicated. One of our most powerful high probability trading strategies, have three or four simple rules – including the entry and exit. What is important about model-driven trading strategies is not that they are complex, but that they are robust (work over a variety of markets and market conditions), accurate (high win per trade win rates) and clear (the rules must be easy to understand and not subject to broad interpretation).
If you are interested in learning more about model-driven trading, click here to reserve your spot at the next presentation on The Machine by Larry Connors. The Machine is the first financial software that helps traders combine quantified, short term trading strategies into objective, high-performing investment portfolios.
David Penn is Editor in Chief at TradingMarkets.com.