Monday, February 20, 2012

EA Trading vs Manual Trading

A client from Malaysia emailed yesterday asking about the merits of trading with EAs. He went through the usual motions of buying "quite a number of EAs [that] promised to make millions and ended up crashing or losing my live accounts." He is not the first, nor will be the last to experience the roller coaster.

He watched a number of videos on YouTube that emphasize the importance of discretionary trading over automated forex robots. They claim, correctly, that a human being understands subtleties that computer programs miss. They then stretch the argument even further and say that EA trading is a fallacy. Given his bad luck, he wondered to what extent that I agree with the argument.

The wrong people are involved in selling EAs (usually)

The argument oversimplifies a difficult concept. Many of you know that I'm a self-confessed math geek. I like numbers. They are logical and they do not vary. What appeals so strongly to me about trading is that you can take a complex process and mold it into a set of logical rules to follow. It's a wonderfully challenging problem. You'll never crack it entirely, but I know from experience that you can develop something that works.

My gripe with most commercial EAs is that the people selling them are not traders. They are internet marketers that stumbled into a highly profitable niche industry. They tick the right boxes for their audience.

Most US forex traders are white men between the ages of 40-65 with an unusually high tendency to earn six figure incomes. The marketing gang knows that themes of financial security and the idea of an job that's not miserable sells well. They focus more on getting that message across than developing a decent product.

EAs are only as good as their designers. OneStepRemoved has designed 1,000+ EAs. I've never seen anyone accidentally program a profitable expert advisor. The ones that do turn out well almost always have years or even decades of trading experience. The rules that they propose usually include subtle distinctions that differentiate between various market conditions and types of volatility.

Those types of people are not marketers. They spent their career trading. It's part of the reason that the meagerly stocked talent pool of traders does not get come into contact with the marketing crew. The other problem is that the guys coming up with strategies worth selling have no incentive to do so.

Unless you're FAP Turbo or MegaDroid, the potential income for most trading robot oriented business is six figures. I've worked with several multimillion dollar trading educators. They seem to do better in the long run owing to the relationships that they form with their customers. They are the exception rather than the rule.

Now look at how much a truly profitable trading strategy can make. Millions. No marketers or affiliates required. No web site. Just a computer and a server. There's no effort required beyond passive monitoring. If you had a trading system that generated blockbuster returns, would you even bother with trying to form it into a business? I wouldn't.

Traders like this do exist. It's just that they're about 0.01% of the trading population. I know this from my brokerage experience because once in a blue moon I fielded their phone calls. They were the perfect clients. They traded all the time, rarely called (only people losing money call their broker) and when they did, it was for some routine matter like withdrawing profits.

The only thing that stood out about them was their account balance. These people are the source of the dream, and they're what keep the remaining 99.99% of algorithmic trading developers going.

Knowing how sweet the setup is if you have something worth selling, and also knowing that the financials really don't make sense for selling a blockbuster system, I honestly would not consider purchasing an EA from the internet. I would never yield control over my account to something that behaves in a manner that I don't understand.

When the drawdown inevitably comes, I would have no way to feel comfortable that the strategy is actually viable in the long haul. I would suspect that the end is nigh and that I better shut down the account before the losses accumulate. How anyone can make an informed financial decision with strictly marketing material is beyond my understanding.

What most expert advisors miss

Trading rules restrict discretionary traders in a way that I find beneficial. It cuts down on their tendency to over-trade, forcing them into situations where patience more often that not wins out.

Todd over at Triple Threat Trading runs a trading education business. He loves to go on and on about how he makes customers quantify their approaches as a set of rules. It's easy enough to lose money in forex or futures.

The rule based approach minimizes those hazards. Following rules eliminates many of the unknown variables from your performance evaluation. Knowing that you followed the rules and still lost reduces the blow to the ego. It's easier to say "the rules lost" instead of "I lost."

The logic naturally flows into the idea of automating the strategy. The chief advantage is that the computer does not fatigue or tire. It follows the rules blindly. So long as a human remotely monitors the execution, the semi-automated approach often works well for established, rule based traders.

Making a trading robot does create new problems like deciding whether to only trade during active sessions or to leave the expert advisor on 24 hours a day. These are usually problems that resolve themselves with a few months of hands on experience.

The main lesson that I learned while running my forex account up this year with a gray box EA is how important it is to stay patient. Most of the systems that I trade personally tend to eat losses way too quickly. I have yet to determine how to quantify patience in trading terms, despite my love for quantifying things.

Certain rules do work dramatically better during different market conditions. The key is to separate the conditions, then apply the strategy selectively. Most expert advisor designers try to develop a strategy that works all the time.

It doesn't work that way. When the EA starts to hit a wall on the design, the trader responds with new additions and tweaks to force the performance to improve the general performance.

What I'm working on now is a set of rules to identify various market types. I like to think of it as "don't compare lawn mowers when it's raining." There's a time and a place for each approach and behavior. The trick isn't so much the rules, but deciding when to apply them.

Categorizing the market helps make the strategy selection process far easier. If the market is highly volatile and ranging, then select a scaling strategy that works well in ranging markets. If the market is trending quietly, then perhaps a basic trend strategy would work perfectly well.