It is absolutely true that in order to succeed in algorithmic trading we need to make at least some assumptions as the building of profitable systems requires us to assume certain things are true which we do not know for certain (as the future is unknown). For example whenever we build a system we assume that in the future currency pairs will behave somewhat like in the past, something that cannot have an absolute basis since we simply do not know if this will be the case (even if it has always happened to some extent). However traders tend to make assumptions which are unnecessary that clearly jeopardize their long term success. These assumptions are not always related to the building of their trading strategies – although they often are – but they also cover several different aspects of trading.
Let us start by saying that we do not have a crystal ball, no oracle and no way to know how the future will be like. Therefore any way in which we plan our trading which involves some assumption about the future will be dangerous. New traders tend to behave a little bit like gamblers, trying to fit their own presumptions and fundamental views about the future of the economy into their trading plan. For example a trader may think that the US dollar will be worthless moving forward and therefore he or she moves all trading assets into different trading accounts which are all denominated in currencies other than the USD. This is an unnecessary assumption which puts the trader at risk since the truth is that if the USD happens to be the complete opposite (strong in the future) it will dramatically diminish the inherent profits of this trader.
An unnecessary assumption is anything you suppose about the future which affects your trading decisions and which you could trade without. In the above example a trader could just as easily diversify into different currency pairs (including the USD) or trade just their home currency (as I detailed on a previous post dealing with account deposit currency choices). Every time you put some of your views about what the future may be like into your trading decisions you’re introducing a fundamental element of uncertainty which is fundamentally a bet against a certain future outcome. You’re in fact making a trade using your fundamental views of the future, something which should not be done unless it is strictly necessary.
Of course – as I mentioned in the beginning of the article – some assumptions are simply necessary if we’re bound to develop algorithmic trading systems. For example we must suppose that past market behavior will mimic future one and that the more we can be profitable through past market conditions the more likely we will be to hold a profit under future changes because we also suppose that the inherent variability of the markets surrounding the patterns within it is in certain ways limited. We assume for example that the market will be inefficient (and neural networks have demonstrated clearly within the past 5 years that it has been this way for at least the past 10 years) and we also assume that these inefficiencies will be tradable. These however are all rational assumptions based on past experience (meaning they have been true for a long time in the past) and they are simply fundamental to trading at all.
However you should understand here that anything you assume beyond what is strictly necessary will imply a bet that will be putting an additional degree of uncertainty around your trading performance. For example limiting your development of strategies to one set of trading tactics or developing systems that make more assumptions that necessary (for example assumptions about execution) is bound to be a bad proposition. For example why would you want to trade a system which poses unnecessary assumptions about how the spreads and slippage will behave in the future if you can just as easily develop systems that do not need to make use of these assumptions?
When developing trading systems it becomes important to analyze what you’re developing and what conditions would need to be true in the future for you to be able to make a profit with them. The more your system depends on some particular way of behavior from the market, (the sustaining of a certain range, certain execution conditions or the continuation of a certain carry trade, etc) the more you will be putting uncertainty and the possibility to fail within the scope of your trading systems. Therefore it becomes obvious that the more you reduce the number of assumptions you make the more likely you will be able to profit in the future because you will not depend on the future turning out a certain particular way. Remember that there are a very large number of possible outcomes for the future and the more of them you’re able to “cover” the more likely you will be to succeed.
This also encompasses diversification and the development of systems. For example – as mentioned on previous posts about robustness – you generally need to make more assumptions for systems which have higher expected profit to draw down ratios but only trading this type of system would be foolish since their inherent capacity to survive to more “potential future scenarios” is further reduced. Therefore it becomes wise to have a wide portfolio in which systems have different inherent levels of robustness such that if the future doesn’t comply with the assumptions made by your strategies with the highest potential at least a good portion of your portfolio will still be making profits. It is however important to realize that it is impossible to trade without making any assumptions (as the mere attempt to speculate into the future stipulates some assumption) but you can always plan your trading and design your strategies in a way which diminishes the amount of assumptions made.
Again, the more future scenarios you strategy “covers” the more you will be able to increase your probability to succeed into the future. If you would also like to learn more about my work in automated trading and how you too can design and evaluate your own trading strategies please consider joining Asirikuy.com, a website filled with educational videos, trading systems, development and a sound, honest and transparent approach towards automated trading in general . I hope you enjoyed this article ! :o)