I’ve been speaking with a few people lately and also looking at the comments on trading systems. A number of people feel that this concept of an “automated trading system” is very strange and it simply won’t work.

Most people quote that they have seen a thousand of them earlier and they didn’t work. While I understand systems tend to fail (especially after they are public for a while), I am willing to bet that most systems “appear” to fail because of the lack of discipline. Most people fear for their life after a few bad trades and have no real way to prove that a system has indeed stopped working; so they throw out the system.

If there’s a series of losses the position sizing techniques (always only risk a percentage of equity, post losses) should keep the position down – but a discretionary impact may be to stop real money and paper trade the next few trades, until there is confirmation that the system has gone bust. Or, to put lesser money in. The concept of throwing out a system on a few trades is probably the most attractive to a human mind, yet, the logical thing is to await some quantitative proof that the system no longer works.

The other problem people have is they are incredulous. How can a system that is computerised and requires no human intervention, perform at any consistent rate? But that’s precisely why it does, because it has no human emotion to contend with. The more humans get involved in trades, the more likely it is for mistakes to happen. Now there are many traders who are excellent at intuition, and the vast majority of trades happen on “gut feel” – so there is always the feeling of a loss of control when you let it all happen in an automated way. But you can’t back-test “gut feel” and you can’t establish how something might have worked in the past when it’s based on intuition.

This goes for a lot of fundamental stuff too. People say that’s better because it’s a more logical way to invest. I doubt it. Fundamentals are scary in these times when companies will lie through their teeth to prevent their stock from falling, or scream buyback, or ask for SEBI to investigate – anything to protect their stock price. You can’t trust anything anyone says – at least one thing you can trust is the stock price! And the concept of buy and hold will soon be apparently flawed, as people who bought RNRL at 212 and DLF at 1200 realise how interesting life becomes when you buy and hold for a long time.

Still, value works – and can be backtested – if there is a measure for value. You can check things like how far below we are from a long term moving average, how much cash a stock has in comparison to price, how much of past earnings growth over say 5 years is reflected in the P/E. These concepts can be back tested, and even automatically traded (imagine, automated fundamental trading!) The concept there may yield far too few trades – maybe a few a year – but may be far more attractive in the long term (10+ years)

Lastly people are cynical about such systems. They think it’s a fad, it will go away. Yes, sorta like fundamental investing “went away”. Or stock markets “go away”. There are examples of HUGE profits from such systems – look at DE Shaw, Jim Simons of Rennaissance Technologies, Ken Griffin of Citadel or Man Investments. These guys manage billions and billions of dollars, through automated systems, and make a ton of money – some put their annual income (performance fees + management fees) as upwards of $1.5 billion. That’s enough to silence most critics – because you only need one such case to DISPROVE the argument that systems don’t work.

I’m not saying other forms of investing don’t work. Warren Buffett’s has, obviously, and so have those of Peter Lynch or Rakesh Jhunjhunwala. Or even the discretionary trading of John Arnold or Steve Cohen. But that doesn’t mean pure automated systems don’t work – they do, as the performance of the big hedge funds mentioned above are well known.

My aim, and Kaushik’s, is to become that kind of automated trading firm for the Indian markets. Obviously we lack the money (otherwise life would be different) to invest in the technology and the connectivity/membership required to make this happen. Also the track record necessary to attract the right kind of money. Keeps us excited!

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