Systematic Trader Toby Carrodus Explains When – And When Not – To Interfere With Your Trading System
Toby Carrodus is a seasoned trader and researcher who has dedicated his career to finding the most effective and efficient way of making consistently profitable trades. Throughout his journey, he has come to appreciate the superiority of a systematic approach to trading. The benefits are clear: systematic strategies can be automated with computers, which do not get emotional or need sleep. Computers can also process vast amounts of data and perform complex calculations much fast than humans can. Even better, ideas can be statistically verified with large amounts of data before risking any money at all. Despite these advantages, Carrodus still has to argue with colleagues from time to time about the importance of not interfering with trading systems.
Such disagreement has led Toby Carrodus to consider and articulate why traders interfere with systematic trading strategies. Carrodus has distilled this into seven different reasons, of which he says only about half are justified.
1. Traders Medicating Their Anxiety
The first reason why traders wish to manually intervene in their trading systems is that humans are simply just emotional animals. We fear the potential for losses at times of heightened uncertainty. Toby Carrodus rightly points out that the future is always uncertain and that by fiddling with trading systems during such times, most traders are merely medicating their anxiety as opposed to making meaningful improvements. From Carrodus’ observations, more often than not, such fiddling yields poorer results than just letting the system run. It also invalidates much of the research that went into designing the trading system in the first place.
2. Traders Justifying Their Salaries
The second reason traders intervene with systematic strategies according to Carrodus is due to the nature of such strategies. They rely heavily on technology and automation. In this environment, traders feel the need to justify their expensive salaries – and existence – and are somewhat incentivized “to do something,” like tweak parameters here and there. Generally, this does not generate meaningful improvements. Rather, it creates additional noise.
3. Event Risk
Toby Carrodus argues that the third reason for system interference – event risk – is nuanced. For regular events, such as non-farm payrolls, FOMC meetings, CPI announcements, etc, arbitrarily reducing system risk is counter to using a systematic approach, as such adjustments could be systematized. Hence, if reducing risk or changing parameters for such events was profitable, it should be incorporated into the strategy. If not, the strategy should be left to run, as there are plenty of such volatility-inducing events in the data sample used to test the system.
Some may push back on this approach in the case of one-off or irregular events, such as Brexit or presidential elections. Carrodus points out that if your trading positions are a function of realized volatility, incorporating forward-looking measures such as option-implied volatility can help systematically address such risks instead.
4. Liquidity
Toby Carrodus explains the aforementioned three reasons for system interference account for the vast majority of fiddling and are largely unwarranted. However, Carrodus also acknowledges that there are legitimate reasons for intervention. For example, if liquidity dries up in a market, the base assumptions of a trading system may become invalidated (that it can trade in a market at a reasonable cost), and it may be necessary to switch off the illiquid market.
5. Data Quality
Toby Carrodus argues that another justifiable reason for intervention is when the quality of the underlying data becomes questionable. If the data becomes sketchy, it may be better to turn off the system until data filters are improved or a better data source is found.
6. Obvious Fundamental Reasons
Carrodus also highlights the importance of having a clear fundamental driver behind a signal. Without a fundamental reason as to why a signal should work, it becomes difficult to stick with the signal during periods of underperformance. Toby Carrodus argues that one needs a fundamental underlying reason for why a signal should work rather than cobbling together a random match of variables and parameters that appear to generate profits in a backtest (machine learning enthusiasts take heed). If a fundamental driver unequivocally changes, this could also be a reason to switch off a signal. But the change should be unequivocal, e.g., a currency signal is unlikely to be useful if a central bank announces currency controls and pegs a Systemcurrency.
7. Refinements
There is no doubting that trading financial markets is a fiercely competitive endeavour. Not only do you need to act counter to basic human nature to be successful, but you are also pitting yourself against some of the best and brightest minds of the world. While there appear to be some longer-term investment strategies that continue to work through time, mostly by virtue of the fact that they are low Sharpe strategies that are difficult to stick with (such as trend following and value investing), at the cutting edge of the spectrum strategies can degrade quite quickly as technology improves and markets change. In this context, Toby Carrodus says it pays to continually focus on research to offset the steady decay in alpha.
In this respect, implementing system improvements based on thorough research is a form of intervention that is warranted, according to Carrodus. Having said that, he still stresses that the bar for including any new signals or system refinements should be incredibly high, as the lure of profits can make it very easy to fool yourself in this game. In the past Carrodus has witnessed sloppy, ad-hoc and inconsistent approaches to research for some researchers, let alone researchers in the same team, and this has been to the detriment of subsequent strategy returns. He would therefore highly recommend developing your own rigorous research protocols to ensure that any system adjustments are genuinely beneficial, statistically valid and are of a high standard.
It Literally Pays to Stay Humble
A final point Toby Carrodus stresses is the importance of staying humble. He says that humans are prone to overestimating their ability and the bar to incorporating new signals into your system should be high. He reminds systematic traders that when they produce a backtest, it relies on assumptions that may not hold in the future, and that it is essential to have a healthy dose of scepticism about the validity of such results.
Toby Carrodus is a knowledgeable and experienced systematic trader with years of experience. He believes that while there are some justified reasons for intervention, the majority of system interference is due to human emotion and the need to justify salaries and existence. Carrodus stresses the importance of having clear fundamental drivers behind signals and staying humble. By following these principles, traders can be confident in the effectiveness of their systematic approach and can avoid making unnecessary and potentially harmful interventions.
“Pop culture advocate. Troublemaker. Friendly student. Proud problem solver.”
