Inefficiencies in Trading : Are There Local and Global Inefficiencies ?

Traders who rely on mechanical trading strategies to profit from the market are most of the time divided between two very different groups. There is a group of traders which believe that a system only “truly works” if it succeeds across a very large array of markets and instruments while there is another smaller group who believes that systems can be created for specific instruments and succeed in the long term. On today’s post I want to share with you an analysis on both views and why both are in fact right, I will point out why successful systems can be created in both situations and why one approach is not necessarily better than the other.

When I started trading mechanical strategies one of the most common pieces of advice I found on books is that a systems that “works” needs to work on a very large amount of instruments. The idea is that if your system truly tackles a market inefficiency it should be able to exploit it on everything from the EUR/USD to the cotton futures and give an overall positive return on a large portfolio. This is the conclusion achieved by many analysts – particularly long term trend followers- after studying the markets for many years. They concluded that instruments can change their behavior through time but these changes usually resemble another instrument’s prior behavior,meaning that a system that works on “many markets” will succeed with a high like hood as it will be prepared to almost “any change” that the market wants to throw at it.

Another argument for this is the fact that curve-fitting can build a very successful system for separate instruments but bluntly fails to do this across a large array of instruments as the degrees of freedom become too limited to achieve such a large adaptation. A system that trades on many instruments with the same parameters therefore has an inherent protection against curve fitting due to this fact.

The main problem of the above hypothesis comes when you consider systematic traders who have succeeded – and in fact many time performed better- by trading merely one instrument on one single market. Such is the case of traders who have specialized on building systems for different forex market instruments, diversifying by building different systems but always trading the same pair.

The difference between both approaches is based on the inefficiencies they exploit and the time frame and focus of these exploitable appearences. The school of traders around the “all instrument” approach builds systems to capture long term trends on daily or higher time frames while the second school builds systems on lower time frames. Since on the lower time frames the different instruments follow drastially different behaviors due to their fundamental underlying characteristics it becomes obvious that different systems are needed for different instruments or at least different parameters are needed to accomodate these differences.

This is the difference between a local and a universal or global inefficiency. Systems that trade higher time frames with the aim of exploiting the longer term behavior can work on many different instruments as they rely on the most obvious expressions of crowd behavior while more specialized systems based on local inefficiencies rely on “finer” characteristics of the different currency pairs, generated by fundamental differences (such as the opening of their most important markets and largest volume hours) which become irrelevant on the largest time frames.

Both of these approaches have their pros and cons. The universal ineffieincy approach has the inherent advantage of being more robust while the local ineficiency approach has the advantage of being more profitable and compounding profits faster, often at the expense of robustness. In order to compensate the two aspects people who wish to trade local inefficiencies need to develop more systems so that if a given system fails to perform (its long term live statistics differ from those found within the long term simulations) it won’t affect the overall portfolio very much. So people who trade a universal system can succeed by trading a single system on 50 different instruments while those who trade local inefficiencies may need 50 systems on a few instruments to achieve a similar level of robustness.

In the end both approaches have been used successfully and both have their own advantages and disadvantages depending on the particular compromises a trader wishes to make. It is however always important to remember that all systems – no matter their time frame – need to be programmed and designed with RELIABLE simulations, sound money management and adaptive trading techniques. In Asirikuy we have tried to go a little bit each way building systems based on both local and universal inefficiencies within the Watukushay project.

If you would like to learn more about how to build trading systems and how you too and learn to exploit both local and universal inefficiencies please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach to automated trading in general . I hope you enjoyed this article ! :o)

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