1. Choosing your broker
No dealing and direct market access
Irrespective of where your trades eventually end up, brokers will deal with your orders in a number of different ways. I’ve listed
these in order of preference; the first type of broker is the best, and the final type is the leas t desirable.
How your orders are dealt
When you are trading with a broker who does not pass through your orders to an exchange, they control the price they are quoting you, not the market . This can lead to some serio us problems.
Problems with broker-quoted prices
Apart from the last problem, which is downright cheating, these are all justified by brokers as they protect their dealing desks from excessive risk. Clearly brokers want to maximize profits, whilst letting their customers take al l the risks.
There is one superficial advantage of trading with a broker that doesn’t pass orders through to the market: you can sometimes trade when the exchange is closed . But you should never do this.
Because brokers can’t hedge their risk when the market is not open, they will quote much wider spreads, making after hours trading much mor e expensive.
You might have to do some digging to find out exactly how your broker trades. If you cannot find the information on their website, then contact them and ask them for their execution policy. A reputable broker will reply, if you don’t hear back then they’re probably b est avoided.
Access to the instruments and products you want to trade I have not explained how to choose which instrument and product to trade. That is coming in chapter six. But, if it turns out you want to spread bet the UK FTSE 100 equity index, then you obviously need a broker who offers this product. If you want to trade inside a tax-free wrapper (UK ISA or SIPP, US IRA or 401K), then again you should check your broker offers this.
You can have more than one broker if a single provider doesn’t satisfy all your needs. I use five brokers! One is cheapest for futures and margin trading, but they don’t offer spread betting, so I do that elsewhere. Another broker is particularly competitive with the fees on their ISA accounts, whilst yet another is best for SIPPs. If you have a large portfolio, it is safer to split it between brokers ; if one fails at least you won’t b e destitute.
Minimum account size
Some brokers require you to deposit a certain minimum amount of money before you start trading. This is particularly common for brokers offering margin accounts or futures trading. As I write this you need at least $2,000 to open a margin account in the US,
and many brokers require more. The broker I currently use for futures and margin trading has a minimum of $10,000.
Currently in the US there is a ‘Pattern Day Trader’ rule, which requires a minimum account value of $25,000 at all times for traders who frequently day trade (opening and closing positions in a single day). However, as you will discover later in this book, I don’t recommend day trading. Hence, this particular minimum is n ot an issue.
Financial stability and regulation
You need to be able to trust your broker. After all, you are going to be handing over your money to them. Choose a broker that is regulated by a competent authority: the SEC in the US, and the FCA in the UK. Stay away from businesses that are based in shady offshore jurisdictions. For example, Israel and Cyprus are delightful places to go on holiday, but they also have a history of hosting dubious brok erage firms.
Strict regulation does not guarantee your broker won’t go bust.
Giant US bank Lehman Brothers employed hundreds of compliance officials, but they still ended up in bankruptcy in 2008. Do some research to check how financially stable your brokerage is. When brokerage MF Global went bankrupt in 2011, the hedge fund I was working for at the time had seen it coming and we had already withdrawn the vast majority of our cash.
This research is a lot easier if your brokerage is a publicly listed company, or part of one. Do not be tempted to cut corners by giving your money to a small firm with opaque accounts, even if they seem amaz ingly cheap.
Costs
The final, important factor when choosing a broker is how much they will charge you to trade. I always pick the cheapest broker, as long as they don’t play games with my orders, are financially stable, and offer the prod ucts I want.
Be wary of brokers advertising superficially cheap headline deals. “Trade for free with zero commission” usually means their trading spreads are wider than the competition. I will explain later in the book how you can calculate the true cost of different products and brokers.
Irrelevant factors when choosing a broker Brokers compete to have the flashiest websites and mobile trading applications. But these are not important. Indeed, an overly complicated interface can make trading harder. Brokers also highlight their generous leverage policy. But you can mostly disregard maximum leverage limits, since sensible traders never use as much leverage as brokers wou ld let them .
Ignore brokers who claim to have some special insight into the market – they don’t. The last thing you need is a broker who wants to give you advice on when, and what, to trade. These brokers usually charge higher fees, or will find some other way of extracting money from you to pay for their ‘valua ble’ advice.
Something that might become important later in your trading 20
career is the ability to trade automatically through an API, ²78
which is the system I use for trading futures. Right now, this is a feature you don’t need to worry about.
How much money do you need?
To run the Starter System – the most basic trading system in this book – you need a minimum of $1,500 or £1,100 (unless your broker requires a larger deposit). This is money you can afford to lose.
You should not have borrowed it or be relying on it as a deposit for a house purchase. Trading is a dangerous business, and even if you follow the rules in this book to the letter there is still a risk you will see some, or all, of your cas h disappear.
20
²75 The spreadsheets can be accessed from the website for this book, systematicmoney.org/leveraged-trading 20
²76 The last clearing house to fail was the Hong Kong Futures Exchange in the aftermath of the 1987 stock market crash. It was rescued by the government, so traders didn’t actually lose any money.
20
²77 Technically they aren’t even brokers, since a broker is an intermediary between you and the market, and your orders never reach the market. The US term ‘bucket shop’ is more appropriate.
20
²78 Application Programme Interface: the method by which your computer communicates with the broker's computer.
Chapter Three
Introduction to Trading Systems
In 2012, I was working at AHL, a large systematic hedge fund. My job was to manage the fixed income portfolio. This involved a vast number of trades in different kinds of leveraged instruments, all betting on interest rates across many countries.
One of our larger positions was in debt issued by a particular European government, which we were exposed to via b ond futures.
One day, I was in the staff restaurant deciding which of the delicious menu options I should sample, when a Very Senior Person from the parent company of AHL tapped me on the shoulder. He was originally from a non-systematic trading background, where decisions were made based entirely on hum an judgment.
“Get rid of those bond futures,” he said, “I have a contact in the finance ministry who tells me they are going to release some 20
very bad econ omic news.” ²79
“Unfortunately, we can’t do that,” I replied nervously, “We’re running a purely systematic fund, and we cannot override the strategy which the computer is running.”
He hissed and stalked off. Difficult as it was to ignore the demands of such a senior manager, I had to let the trading system ru n unimpeded.
Systematic trading is trading ‘by the book’. It’s following
the rules. It’s not ignoring some of the rules because you think you know better. It’s not following the rules most of the time, then putting them aside when they don’t suit you. In this chapter, I’ll explain which rules you can safely ignore when you have more trading experience, and which rules should neve r be broken.
Why you should use a trading system
Trading systems ha ve two jobs:
Deciding when to open a new position, and whether to go lo ng or short.
Deciding the size of position you should have, and how long to hold it for.
I believe that everyone should use a system for the latter, and almost everyone should use a system for the former.
Why you should (usually) use a trading system to decide whether to buy or sell
Humans are really smart. They can analyse complex information, detect clear patterns in murky data, and their capacity to understand other people is vital when playing games like poker.
But humans are also really dumb. They are emotional. They frequently ignore rational analysis and make decisions purely on gut feel. Their decision-making is hampered by behavioral biases and they do the same stupid things over, and over, again. They overestimate their ability to predict the future. This is not just my opinion. There has been plenty of research by Nobel prize 20
winning economists and psychologists, ³70 showing how and why humans make key errors.
Take one specific example of human incompetence: most people sell out quickly when they make profits, but hang on to positions where they are suffering losses. This makes no rational sense.
The market doesn’t know or care where you entered the trade and is utterly indifferent to your profits or losses, so it is irrational to get rid of winning trades and hold onto losing ones.
Psychologically, however, it makes perfect sense. Humans enjoy the feeling of being right when they have made money and want to quickly bank their profits in case they evaporate. When losing, they do not want to sell, thus admitting they have made a mistake. ³¹ As a result, where there has been a slew of good news stocks can experience some weakness, as they have been sold by humans taking a qu ick profit. ³²
Simple trading systems have a number of advantages over h uman beings.
Firstly, they won’t succumb to h uman biases.
Secondly, they can exploit those biases. If human traders continue to do the wrong thing, then doing the opposite thing can be a profitable strategy. The Starter System I introduce in chapter five does exactly that; it reverses the human predilection to cut winners and let losses run. It identifies trends in the market and then follows them: it’s a trend-following or mome ntum system.
Thirdly, running a trading system is a repeatable process.
Traders who rely on gut feeling can have bad days when they are not emotionally or physically ‘in the zone’. If you are following a system, then you can still trade just as effectively, even if your team lost a big game yesterday or you are suffering from a heavy cold.
Repeatability also means your system can be simulated using historical data: a process called back-testing . Back-testing will tell you if something worked in the past. This is no guarantee it will work in the future, but it’s a good start nonetheless. More importantly, back-testing indicates how you should expect your system to behave . How likely is it you will lose 10% of your account in a week? How many trades should you expect to do every year? Back-testing can answer these questions, an d many more.
I will not cover the mechanics of back-testing in this book. ³³
You do not need to do any back-testing, since I have already back-tested all the systems in this book.
Repeatability also means your system can be automated , but again 20
that is not co vered here. ³74
If a system is repeatable then you can easily apply the same rules to many different instruments, giving you diversification
. Diversification is the holy grail of finance, as it results in a significant improvement to your expected trading returns. I discuss diversification further in part three o f this book.
In summary, simple systems make better trading forecasts than the vast majority of human traders . Some very experienced people can predict the market with better accuracy than any system, but
traders who are just starting out should instead delegate their decisions to systematic tr ading rules.
Why you should always use a trading system to decide the size and duration of your trades
I frequently get asked: is trading an art or a science? My answer: the decision to go long or short is perhaps an art for a few gifted traders, but choosing position size and trading frequency are definitely a science where you should follo w set rules .
Certain highly skilled and experienced traders can do better than simple trading systems when it comes to making buy or sell decisions. This is the part of a trading system whose rules you can consider breaking: once you have gained enough experience and can be confident of your ability. I discuss how you can know if you are ready for this in the final chapter. But I firmly believe that you should always stick to a system when it comes to deciding (i) how large your positions should be, and (ii) how 20
long you should hol d them for. ³75
Why? Well, human traders are usually overconfident. They overestimate how good they are relative to other people, and they make predictions about the future whilst underestimating uncertainty. Most traders conclude that it is possible to make consistently high trad ing profits.
This leads to two serious problems. Firstly, people assume that it’s safe to make huge bets, boosting their returns further using massive leverage. Secondly, they want to trade more often, with each extra trade ‘guaranteed’ to make further profits. These are both hu ge mistakes.
By contrast a properly tested trading system will give you a realistic idea of what your likely profitability is. It is possible to calibrate the system to ensure that you have the right amount of leverage. You can also calculate your likely trading costs and adapt the system to keep costs down to a sen sible level.
Naturally, I’ve already calibrated all the systems in this book, so they don’t bet the farm and pay reasonable costs. Once you have a good system, then following it rigorously will ensure you avoid the usual human failings of taking too much risk and trading too frequently.
Common arguments against using trading systems I often encounter disbelief that a simple system can do a better job of trading than a skilled human. Here are some of the arguments I’ve heard, and m y responses: What makes a good trading system?
There are three characteristics of a good tra ding system: No exce ssive risks.
Doesn’t trad e too often.
Doesn’t assume the past will repeat exactly in the future.
Let’s look at each of th ese in turn.
1. No excessive risks
Overconfident traders take too much risk. They get greedy. They use too much leverage. If you can earn $500 on a trade by risking $100 of the $1,000 in your account, then surely you can earn $5,000 by risking the en tire $1,000?
As I will explain in chapter five, ramping up your leverage beyond sensible levels can turn a winning strategy into a sure-fire loser. Keeping your leverage at the right level will improve the chances that you end up profitable, even though it means sacrificing a tiny chance of a really big payoff.
1. Doesn’t trade too often
Many people assume trading is a simple numbers game. Trade more, and you will make more. If you can make $100 trading once a week surely it makes sense to trade every day and make $500 a week? Or trade hourly and make $4 ,000 a week?
But trading faster means you are handing over more money to your broker, via the trading spread, commissions, or both. Your trading profits are going to need to overcome the headwind of all those extra costs. Unlike costs, those extra profits are uncertain. There is a remote chance you could end up making sufficient additional profits to cover your costs, but it is more likely you will end
u p worse off.
Good systems keep their costs low and trade relati vely slowly.
1. Doesn’t assume the past will repeat exactly in the future This is the sin of curve-fitting or over-fitting . It is analogous to the common human trader error of overconfidence . An over-fitted trading system will have a complex set of rules and dozens of parameters – the numbers that control how the rules behave. It will work fantastically well when run over historic data, but unless the future is exactly like the past then it will not be as profitable when you actually trade it and will almost certainly be inferior to a much sim pler system.
Good trading systems for beginners
The three characteristics I’ve listed above are important for all traders. But trading novices must consider some additional
requirements. Firstly, the system should be relatively simple to run . An overly complicated set of rules will make it difficult to understand. You are more likely to ignore the rules if they are too complex. The Starter System I introduce later in the book is not as simple as many others, but it is as simple as it can be without becomin g dangerous.
Secondly, if you are a newcomer to trading you should not invest in fancy software or hardware or cough up for expensive data feeds. You probably don’t have much spare cash at your disposal, and what you have should be reserved entirely for trading, not spent on unnecessary technology. All the systems in this book can be traded with data that is available for free from many websites, and a simple spreadsheet.
Thirdly, like I just said, you probably don’t have much cash for trading with. There is no point using a system which is designed to run with $100,000, if your trading account contains just $5,000. The Starter System can be traded with just $1,50 0 or
£1,100.
Why you should avoid third party trading systems This book is pretty long and will require some effort to understand. Why bother? Instead, get someone else to do the work for you. An expert advisor (EA) or trading robot is a computer algorithm that will do your systematic trading. Alternatively, you can try copy trading , where your account automatically duplicates another trader’s buy s and sells.
Leveraged Trading: A professional approach to trading FX, stocks on margin, CFDs, spread bets and futures for all traders Page 6
