Predicting the past

I can predict the future. Although, if that were even remotely true, I probably wouldn't be sitting here writing a blog. Instead, I'd be lounging about on a beach somewhere. However, despite it being a totally inaccurate statement, I hope that it has encouraged you, the reader, to take a few moments to finish reading this article.

The problem with the future is that no one really knows what will happen. I remember when I was a kid. The notion of a phone having a computer in my pocket would have seemed laughable. The idea that computers would be so ubiquitous would simply be beyond my comprehension. Indeed, a similar point about the role of technology in trading was made by my good friend Pierre Lequeux speaking on a panel at the recent TradeTech FX. The difficulty with trying to predict the future doesn't prevent us from trying. Over the past weeks and months, the market has been musing about when the Fed could begin a hiking cycle, it's first in over several decades (ok, not quite, but it has been a long time since the Fed actually started a hiking cycle). What has complicated matters, is that even if the Fed does hike, what will that mean for markets?

A systematic trader does not attempt to predict the future (to an extent). I find it incredibly difficult to forecast when the systematic trading strategy that I've been running will make or lose money from day to day. This is despite the fact that the overall trajectory of returns has been upwards since I started trading my own cash just over 2 years ago. The objective is more about creating a strategy which is profitable over the long term on average.

Systematic traders rely upon patterns from the past persisting into the future, which on average have been profitable and have a good rational explanation. We can also look at the past to try to understand what happened to our trading strategy in similar situations, which might crop up in the future. The great thing about having a systematic trading strategy is that whilst we can't tell the future with certainty, we definitely know the past! I've been in the market for around a decade, and during that time I've run all manner of different systematic strategies. I can create a new trading system and then use historical data to understand how a strategy coped with the start of Fed hikes as an example, well before I even started working in currency markets.

Hence, even though I can't tell you precisely when a Fed hike will be, I can tell you how confident (or not) I would be with a trading strategy to cope with similar historical events. A discretionary trader can look back at their own P&L history to see how they coped with historical events, but unless they have been trading for a long time, they might be a bit stuck when trying to identify events before they started trading. I recently published a Thalesians paper, for example, discussing how CTA strategies have performed at the start of Fed hikes to test this idea.

Of course, there are caveats. The past is never precisely like the future. There will be unusual events that are not in our historical sample, which could impact our portfolio significantly. Indeed, this Fed hiking cycle could be very different to previous ones as an example (the Fed has never begun hikes from such a low level). At the same time, there are likely to be many historical events similar to future ones.

Whilst systematic trading isn't for everyone (just as discretionary trading isn't), the ability to look at historical data, gives us an ability to see how robust our portfolio has been to historical shocks and to check how our strategy has behaved. Even with all the mathematics that goes on behind creating a systematic trading strategy, perhaps the most important thing, is to have a modicum of common sense and understanding of risk!

If you're on the US East Coast, I'll be in Washington DC 27 Sep, NYC 29 Sep-3 Oct and Boston 5 Oct if you'd like to meet me and hear more about systematic trading! If you're in mainland Europe, I'll be in Paris 6-9 Oct at the WBS Fixed Income conference, where I'll be hosting a systematic trading workshop.

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 interested in me writing something for you or creating a systematic trading strategy for you! Please also come to our regular finance talks in London, New York, Budapest, Prague, Frankfurt, Zurich & San Francisco - join our Meetup.com group for more details here (Thalesians calendar below)

21 Sep - New York - Agostino Capponi - Arbitrage-Free Pricing of XVA (Thalesians/IAQF)
23 Sep - London - Stephen Pulman - Multi-Dimensional Sentiment Analysis
01 Oct - New York - Saeed Amen - How to build a CTA? / interactive Python demo
05 Oct - Boston - Saeed Amen - Trading Thalesians Book Talk / PyThalesians Python Interactive Demo (Boston Algorithmic Trading Meetup Group)
09 Oct - Budapest - Taylor Spears - On the Sociology of CVA
14 Oct - New York - Dan Pirjol - Can one price Eurodollar futures in Black-Derman-Toy? (Thalesians/IAQF)
21 Oct - London - Robert Carver - Lessons from systematic trading