Unearthing Trading Secrets: Adrian Reid on Mastering the Systematic Approach

There are people who trade, and there are people who make computers do the hard work for them? How? By building a system and testing it. Adrian Reid explains some of the pitfalls of both approaches and unveils what he wishes he had known much sooner in his trading career.

Summary – IBKR Podcasts Ep. 110

The following is a summary of a live audio recording and may contain errors in spelling or grammar. Although IBKR has edited for clarity no material changes have been made.

Andrew Wilkinson

Welcome everybody to today’s podcast. My name is Andrew Wilkinson. I am very pleased to have with me today, Adrian Reid, who is the founder of Enlightened Stock Trading all the way from Australia. Welcome, Adrian. How are you?

Adrian Reid

Andrew, I’m great. Thanks so much for having me.

Andrew Wilkinson

You’re very welcome. Now you’re going to talk about a topic that I really appreciated in the 1990s as I watched the growth of prop trading, (proprietary trading) and hedge funds and The Turtles and all those kind of guys grow and they did something called systematic trading. Just enlighten us a little bit, Adrian. Tell us about systematic trading and what the topic of today’s podcast is.

Adrian Reid

Sure, Andrew. Thanks so much. You’re right, systematic trading has been around for a long time now and really popularized initially by the Turtles I suspect. What systematic trading is is essentially rules-based trading. What we do is we put rules in place that completely remove the subjectivity from our trading decisions and this is super important as we’ll see as we get into the discussion, because as humans we’re not really wired mentally to be great traders and so we have to put some rules in place to get around our human shortcomings. So systematic trading, it doesn’t have to be complex, it’s not necessarily rocket science or particle physics. It’s all about simple rules that take advantage of known market biases, known market behaviors, and they identify when that behavior starts, when it stops to get you in and out with a positive expectation of profit essentially. Does that make sense?

Andrew Wilkinson

Taking the emotion out of everything, right?

Adrian Reid

Absolutely, because the emotion is one of the biggest killers of trading results because as humans, you know, we’re emotional beings, but when we step into the financial world, that emotion absolutely doesn’t serve us and we’ve got to find a way to to remove the emotion so we can make objective clinical decisions in the in the financial markets.

Andrew Wilkinson

OK, Adrian, so let let’s jump straight in and and let’s ask that question that probably every trader wants to know: Why is trading so hard and what can we do about it?

Adrian Reid

It is hard. I mean it’s one of the unfortunate realities of the trading life. We come to the financial markets initially, at least, most people thinking, wow, you know, stocks go up, stocks go down; futures go up, futures go down. If I just buy low, sell high, I can make money and I’ll be rich. But the reality is vastly different and it’s for a number of reasons. First of all, let’s touch on the emotion. When humans evolved, we evolved with instincts that kept us alive, and those instincts did things like raise when something happened that would scare us, you know, a lion or a tiger, a wild animal: Our emotions would go up. We would get an injection of cortisol, a stress hormone, into our system. Blood would rush to the extremities. We’d get ready to fight or run. And the blood would drain from our brain because we weren’t interested in making decisions at that point. What we were interested in doing is surviving, surviving the physical threat. Now, fast forward to today in the financial markets, we have something that causes fear; losses, volatility, et cetera. And those now non-physical threats, they’re financial threats cause the same physical reaction in our bodies. So, our motion goes up, intelligence goes down, makes it very hard to make good financial decisions. And so, we make emotionally-driven decisions and we lose money. So, the emotion is the critical thing.

Secondly, we have all of these biases, psychological biases, that affect our ability to make good decisions, right? So, I mean, there’s countless dozens of cognitive biases. Loss aversion is probably one of the big ones that affects traders. So, for example, the pain of losing $100 is more than the pleasure of gaining $100. Now, what does that mean? Well, if you think about having a position in a market, if it goes down by $100, we feel that in a magnified way compared to if the the position goes in our favor. And that means we’re more likely to behave badly as traders when it comes to losses than it is to gains. So, it leads ultimately to the small gains, big losses sort of scenario which is an account killer. So, there’s many reasons like this and it’s mostly psychological that trading is very, very difficult.

Andrew Wilkinson

So, let’s just distinguish then between a discretionary trader and a systematic trader. Just explain the distinction between the two, but moreover, what makes for a successful discretionary trader versus a successful systematic trader?

Adrian Reid

Yeah, great question. So, first of all, what is a discretionary trader is someone who is (a) not systematic, but really (b) who is looking at various different sources of information; could be news, could be fundamental information, could be information on chart indicators, could be all of that, and piecing together a decision on a case-by-case basis, essentially using weight of the evidence like what makes sense now with all of the information I can gather and trying to make that decision.

Andrew Wilkinson

That’s a very emotional trading style.

Adrian Reid

Well, absolutely could be and this comes to the crux of what makes a successful discretionary trader versus what makes a successful systematic trader, because a successful discretionary trader needs to be able to take all of those sources of information, assemble them logically, create a sound and repeatable argument so that they can make a good quality decision. That means you’ve got to get through all of the emotion. You’ve got to get around all of the cognitive biases that as humans we hold, and you’ve got to make a decision and you’ve got to have confidence in that decision. So, to be a successful discretionary trader, you need to be exceptionally clear in the mind. You need to have dealt with a lot of your financial issues. You certainly can’t afford to have any money issues or self-worth issues or anything like that and you need to be very consistent in your decision-making process.

Now, contrast that with the systematic trader. You can have all of these crazy things going on in your mind, but if the rules say buy, it’s clearly a buy. If the rules say sell, it’s clearly a sell. What’s left for the trader to do is to pull the trigger and actually place that order, or to take themselves out of the process entirely and automate the whole thing. So, by being a systematic trader, what you’re doing is you’re bypassing a lot of the work that has to be done to become successful in a discretionary sense, because you don’t have to make those decisions consistently. The system does it for you. What you need is a good system, and you need to be able to pull a trigger and execute it. So, to become successful systematically, it’s actually much simpler and faster.

Andrew Wilkinson

Now, Adrian, we hear the term back testing a lot when it comes to systematic trading, but the future will not be the same as the past. What’s that expression? The future rhymes, but it never repeats. But why is back testing so useful?

Adrian Reid

Yeah, back testing is one of the most powerful tools for traders, when used correctly. When used badly, it also can be destructive. It’s super powerful because it gives us an insight into what works and what doesn’t. Now we can’t predict the future. That’s absolutely true. However, we do have a lot of market history. We’ve got history of market behavior through bull market, sideways market bear market, interest rates going up, interest rates going down, war, famine, peace, protest, violence, assassinations. All of these things. And so, we have some evidence of what the market will do under certain conditions. Now, back testing allows us to take our rules and apply it to all of that data and see how those rules would have performed through all of those different market conditions. Now, yes, the market tomorrow and next year will be different to what it was in the past but, if our rules never made money in the past, the chances of them miraculously turning around and making money in the future are exceedingly slim. I would say zero. But if our rules when back tested, made money through bull markets, bear markets, sideways markets, interest rates up, interest rates down, et cetera, then we’ve got a much better chance of making money in the future. And as traders, what we’ve got to do is tilt the probabilities in our favor as much as we can, and back testing is a super powerful tool to do that. Back testing is a really deep subject. We’re not going to be able to get into it today. Just one simple example is to kind of clarify a little more. A lot of people talk about over optimization and how you can fine tune the back test or the rules to pass data and then it has no predictive value. And that’s absolutely true. But what if you have a system that has a couple of simple rules and those rules, it doesn’t matter whether the moving average you use is a 200-day moving average or 100-day moving average or a 300-day moving average, all of those parameter values worked in the past. The system was stable. It made money over a wide range of parameter values. That gives you huge confidence that the system will work or is more likely to work in the future because it works over a wide range of conditions in the past. That’s why back testing is so important, it gives confidence that we’ve actually got an edge.

Andrew Wilkinson

But there must be some pitfalls.  What are the ones to watch out for? Some of the the biggest pitfalls that systematic traders need to look out for?

Adrian Reid

The biggest pitfalls again related to back testing. The first one I would say would be overfitting. Overfitting means you fine tune your rules too closely to pass data. Now, we have to fine tune our rules to some extent to capture past behavior, but when you go too far, you introduce too many variables into or too many rules into your system you fine tune the parameter values too much to particular trades. That’s when you start leading yourself into difficult, difficult territory, troubling territory because it might look great in the past, but it won’t work well in the future. You need a very generalized model. That would be the first pitfall.

The second pitfall, I would say, would be insufficient diversification. A lot of people come into the markets and say, OK, well, I’m going to trade stocks in the S&P 500 and I’m going to use a mean reversion strategy, for example. Now that might great some of the time, but it won’t work all of the time, so diversification across a range of different strategies, different systems are really important because no one system or strategy will make money all the time. So, lack of diversification would be the second pitfall.

The third one is not thinking beyond the back test. Let me give you a good example of this. It’s typically in the area of risk management. You could back test your strategy, your system and find that it works really well with two times leverage and 10% of your account allocated to each trade. And the equity curve looks nice and smooth, the drawdowns are low and so on. But thinking beyond the back test is asking yourself the question, what else could go wrong here that I’m not seeing in the data? And I think this is where I’ve managed to be very successful in my own trading career, having never blown up an account. The reason I’ve never blown up an account is because I’ve always asked myself this question. What else could go wrong that I’m not seeing? You know what would happen if the market crashed 30% overnight? What would happen if this stock went bankrupt, what would happen if trading was suspended on this exchange for a number of days or weeks? What would happen if all of these scenarios, by thinking beyond the back test into some scenarios like this, you set yourself up for a much more stable, much more successful trading career. And I don’t think enough traders do that.

Andrew Wilkinson

So, Adrian, you’ve been investing and using systems for quite some time. If you had to look over your shoulder across your trading career, what are the top three lessons, for example, that you wish you’d learned earlier and that you could impart with the audience today?

Adrian Reid

Ohh wow, if I had a time machine I would be so much wealthier and not even because I would know what stock to buy or when to buy into crypto or any of those things. Just because a couple of lessons makes so much difference. So, what’s the biggest one? The biggest one would be to go systematic immediately. I spent three years struggling with discretionary methods trying to find consistency, trying to find an edge, and then I realized that my emotions were constantly getting the better of me. And that three years has cost me millions in compounding, with, you know, with no exaggeration, actually did the calculation. If I got the returns from the beginning to now as opposed to three years in when I started being systematic and got profitable, to now, it is literally a seven-figure number. So, that’s the first lesson. Go systematic immediately because you can start compounding with consistency and certainty sooner.

The second lesson: Trade long short. I think probably it would have been seven years before I took my first short trade. And that’s just way too long, because the market doesn’t always go up. Now, yes you can trade long only and you can be successful, but if you can make money when the market is falling, which is absolutely possible, if you can make money when the market is falling, your equity curve at the end of the bear market is higher, so that when the next bull market comes, you’ve got a higher high watermark to start compounding from. So, even if you can make a little bit of money when the markets are falling instead of having a 30-40-50% drawdown like most people do, then you end up in a way better spot later on.

Third and final lesson, diversify and automate earlier. You know, I was pretty slow to do certain things. I was slow to go systematic. I was slow to trade short and I was slow to diversify. I mean I traded only Australian stocks. I’m Australian, I traded only Australian stocks for 10 years before I went offshore, and that was a mistake. And I would say no matter which country you live in, trading, only the stocks in your own country is possibly a mistake from a diversification point of view, because different markets move differently. They have different personalities. They have different fundamental drivers. They have different speeds in nature of trends. So, now I trade Australia, US, Hong Kong and Canadian stocks and the diversification you get in that is so powerful. So, I would do that far sooner as well.

Andrew Wilkinson

What path would you suggest traders take when looking to become systematic or algo traders Adrian?

Adrian Reid

Yeah, it’s a good question. And it’s challenging because in trading, there’s a lot of information and a lot of traders will go, ‘Ohh, OK. I’ve discovered systematic trading. I better build my own system’. And that sounds like a sensible idea, because, ‘OK, it’ll be mine. No one else will use it. I’ll have confidence in it’. But the trouble is building your own system is actually quite hard. So, I think the the path that makes the most sense and and the path that I’ve seen others have the most success with is to find a system that clearly works. Now, it doesn’t have to be the best system in the world. It doesn’t have to have ultra smooth returns or very high returns. It’s just got to work and get into the market systematically with a small level of risk and a small exposure. So, a simple trend following system is a great place to start for many people and with just a small amount of money. Just get the sense for trading systematically. Once you do that, you learn so much about being a systematic trader. You know, you learn about what it means to follow rules when psychologically you really don’t want to. You learn what it means about having confidence in your strategy. You learn what it means about the diversification and the level of risk management you’ve got to have. When you’ve got a system, then it’s time to really learn to back test and evaluate. Because what drives success is confidence and an edge. But to have confidence and an edge, you need to be able to back test your strategy correctly and back testing doesn’t mean throwing your rules into some software, pressing optimize and finding the best combination out of 360,000 variables. It’s actually quite a nuanced process, so spend some time to learn back testing correctly. That will build your confidence and allow you to follow your rules through good times and bad. Once you’ve got a strategy and you’ve learned to back test and you’ve built confidence in that strategy, it’s time to start to diversify. Add some strategies, some systems that trade different, a different underlying market behavior, mean reversion, trend following, for example, long short. U.S. market, Australian market, Hong Kong market, something like that; Start to diversify. Once you’ve diversified, you’ll find all my workload is really increasing. That’s when it makes sense to automate.

A lot of people come into the market and say, ‘Ohh systematic trading, I’m going to automate with the bot on day one!’ And it’s fraught with danger because there’s so many lessons you don’t know yet and if you put all of your systematic trading on hyper speed before you’ve learned all of those lessons, guess what? You’re going to have an ugly, ugly surprise. So, automate once you’ve learned some of those lessons and you’ve got much more confidence in your back test, in your system. And automation then takes you out of the game, allows the trading to happen consistently, reduces the number of mistakes dramatically. Once you’ve automated, you’re then in a position to diversify even further to things that naturally you wouldn’t do. And so that’s the process that I would go through. Start with a simple system, learn to back test and really stabilize your strategy and your confidence, then diversify to a couple of different strategies, then automate so you can diversify further as your capital grows.

Andrew Wilkinson

How many different strategies might you be running when you’re full on? In fact, when you’re not full on if at the minimum when you’re cruising and doing very little, how many strategies might you have on and at the max what are you going to have on?

Adrian Reid

Look, I would be running, I mean my strategies run all the time, so all of them, but they can turn themselves on and off. So, in stocks it would be a dozen strategies easily, but at any one time, three or four of them might be giving signals. And that will vary quite a bit from day-to-day, month-to-month. In crypto I’ve got nine strategies, and a couple of variations of those nine. So, the thing is, once you’re automated, it’s very easy to start to add some variations to get a bit of extra diversity without any extra effort really.

Andrew Wilkinson

What about a currency strategy?

Adrian Reid

I don’t actually trade currencies, so that’s currencies and futures. Currencies and futures is an area that I want to push into. I guess I’ve probably been too busy with the teaching side of my work to do a whole lot on the development side of my work in the last couple of years. But I definitely want to add some systematic approaches to currency futures.

Andrew Wilkinson

I always was of the belief, my understanding was that currencies trend very well, particularly, for short term strategy.

Adrian Reid

Yeah, I think it’s true. I think you probably need to go to a smaller bar size than daily for that to really be true.

Andrew Wilkinson

Oh, absolutely. I mean, you’re talking one minute [bars].

Adrian Reid

And I’ve only really worked on the daily time frame because, well, for a whole variety of reasons, I guess. But you know, I had a day job when I first started, and then when I didn’t, when I didn’t have a day job, I didn’t have automation. And so, I wasn’t really interested in sitting at the screen watching things unfold. But now that I’m comfortable with the concept of automation, which was another thing I was slow to do. I think that opens that up. So yeah.

Andrew Wilkinson

And you said in the same breath the futures as well, you’re not doing that?

Adrian Reid

No, I don’t trade futures I have, but I don’t at the moment. And I look, I think it’s an important part of a diversified systematic portfolio. It’s just a matter of time and energy.

Andrew Wilkinson

Adrian, this has been an excellent primer on how to evaluate and look at systems. Thank you very much for joining me today. And I think just for the for the benefit of the audience, we’ll probably have a couple of live webinars with Adrian before the end of 2023. And if you can’t wait to attend those, I would encourage you to go and have a look at the IBKRCampus.com. Under the contributors, look for Adrian under Enlightened stock Trading. We’ve got four webinars recorded there. They’re all wonderful commentaries from Adrian with me as the host there and if you access any of them, there’s a great PDF download for you to just dive straight into if you want and you’re welcome to watch the recording. So, Adrian, you’ll be with us online again before the end of the year.

Adrian Reid

Looking forward to it, I can’t wait to do the next webinar. We’ve got one coming up in a couple of weeks’ time, so looking forward to that.

Andrew Wilkinson

So, folks go to IBKRWebinars.com to register Adrian Reid, founder at Enlightened Stock Trading. Thank you so much for getting up so early in Australia this morning to join me.

Adrian Reid

Andrew, thanks so much for having me. Always a pleasure.

Andrew Wilkinson

Thank you. Bye for now folks.