Saturday, 7 March 2015

Macarons, sandwiches & creating trading strategies

07:48 Posted by The Thalesians (@thalesians) No comments

Archaeological evidence suggests that humans have produced bread for at least thirty thousand years. Meat has been a part of humans' diets for much longer, when we were hunter gatherers. In recent millennia, animals were domesticated making it somewhat easier for humans to consume meat. However, whichever diet you choose to have, executing it requires adequate time to actually eat. When engrossed in a task which requires significant concentration, it can be easy to lose track of time, only to notice the gentle rumblings of your stomach reminding you to eat. I have been guilty of this on many occasions, in particular when I was writing my book (Trading Thalesians) and faced an impending deadline!

In the eighteenth century, for John Montagu, his mind was on gambling. He could remain at a gaming table for hours, time enough for hunger to strike. One solution would be to simply get up and have a meal elsewhere. However, this would interrupt his play. Instead, he suggested that his servants create a meal consisting of two slices of bread separated by a filing. This came to be known as the sandwich, after its inventor, the Earl of Sandwich, namely Montagu himself. Fast forward over a hundred years and the concept of the sandwich evolved into the burger supposedly at Louis Lunch establishment in 1900 (although Wikipedia lists several other potential inventors). Despite ingredients for sandwiches being easily accessible for millennia, it clearly took a long time for a stroke of brilliance to combine them.

If we think of other more complicated dishes, it is far less obvious how to create them, even if the ingredients are widely available. Take for example macarons. First, whilst, they are becoming more familiar in high street bakeries, I suspect most people are not fully aware of all the ingredients you would use for them, without consulting a recipe book (unlike sandwiches). Second, the steps required to bake them are numerous and often not intuitive. Even if you follow the recipe precisely, it is very easy to make subtle mistakes in their preparation, which render a macaron looking like an unrecognisable mess, even if it does taste fine (as an aside, the red macarons in the photo, were ones I made... my many previous attempts looked absolutely awful).

When it comes to thinking up of ideas for profitable trading strategies, we can use the analogy of the creation of sandwiches and macarons to illustrate the general thought processes. We can think of "sandwich" strategies as requiring little in the way of complexity. What they do require however, is for you to think of the concept to begin with. Indeed, it might require a significant amount of work to come up with the initial idea, but the actual resulting trading strategy is relatively simple. How do you increase the chances of coming up with a "sandwich" strategy?

  • Observing the market on a regular basis, can help uncover strategies. Are there any patterns you can spot? What are the explanations for these patterns? If we look at the data are our initial ideas confirmed?
  • Around market events, what type of price action do you tend to notice?
  • When do you tend to lose money and when do you tend to make money, when you trade? Trading with real cash is like a "special" backtest which you can never forget!
  • Simply talking to others in the market, you might pick up inspiration.
  • Markets interact with the real world, you might get ideas from other areas!
  • A lot of the times, it might involve trying to mimic investor behaviour you have observed and modelling that. If you have an idea to begin with, it becomes easier to model, rather than searching in the dark.
  • As with everything, experience is very valuable for uncovering systematic trading ideas!

Macaron style strategies are somewhat more difficult to create. Here the general concept can sometimes be relatively "simple", for example, using news data to trade markets. However, actually implementing the idea in practice, requires a lot of detailed work and steps to get it right. All the points important for a "sandwich" strategy are still relevant. However, we might have other issues to deal with, if we're trying to come up with a macaron-like strategy:

  • Even before starting our backtest, we note these ideas require a decent technical base to implement, whether it's certain mathematical techniques or coding.
  • There might also be a significant amount of data which needs to be managed effectively.
  • In other words, we probably can't use Excel to implement our trading strategy!
  • Given the number of steps a final algorithm might end up having, we need to be even more careful about data mining. In particular, is there always a rationale about a particular step you using? Making a trading strategy unnecessarily complicated does not make it run better in real life.
  • Try not to lose sight of the original idea amid all the detailed implementation.
  • There might be multiple quite different ways to implement the same idea.

Of course none of this is easy, but with a bit of luck and experience it is possible to build profitable trading strategies. Even once you've created a good trading strategy, there is also the important question of how you manage risk around it, when actually trading it. Fail do that properly, and you can render even the most robust of tradings strategies unprofitable! One question remains, which do you prefer, burgers or macarons? I would suggest both for a balanced trading book (and diet).

Like my writing? Have a look at my book Trading Thalesians - What the ancient world can teach us about trading today is on Palgrave Macmillan. You can order the book on Amazon. Drop me a message if you're interesting in me writing something for you or creating a systematic trading strategy for you!


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