The Weakest Link: balancing algorithmic expertise and fundamental understanding in trading

By Max Rybinski, Head of Proprietary Trading, JM Asset Management Ltd.

As electronic trading extends further from institutional into retail trading, how well do today’s traders know the building blocks of the tools they employ?

profile03Electronic trading rules Hong Kong’s trading, just as it does around most of the developed world. The popularization of online discount brokers, targeted social media advertisements, sophisticated platforms, along with faster data connectivity, have also created a swell of retail trader confidence in electronic trading tools.

Unfortunately, many of these retail traders will lose most, if not all, of their money in a very short period. Easy access to trading technology is to blame. It has become very affordable, accessible and complex trading strategies have very simple execution options that only require a click of a mouse.

Algos without fundamentals
Our new reality is that most retail traders here in Hong Kong specialize in using electronic trading tools, but can barely scratch the surface when trying to understand the underlying strategy. Therefore, when the market conditions are in flux, traders should know how the strategy will behave and have the skills to adjust accordingly.

In the institutional trading space, the current generation of traders has all come up after the mass adoption of electronic trading, which raises the question whether they may also be overly reliant on pre-built electronic execution strategies.

Having started my career on manual trading desks, working with traders with a wide range of successful trading strategies, and now developing algorithmic strategies to execute in the market, I have seen the benefits of each approach. More importantly, I have seen the skills that each approach requires and fosters among the traders that employ it.

I do not intend to demean the quality of the trading talent in Hong Kong, but if the majority of traders merely supervise a fully automated electronic system, are they familiar enough with the fundamentals of developing a trading strategy? By no fault of their own, the industry has shifted to a fully electronic system and developing the understanding of the fundamental underpinnings of algorithmic strategies has not been sufficiently addressed.

There are core fundamental skills that appear to be receding from the industry. If these are reduced, will it inhibit a trader’s ability to understand and service their clients’ needs? Are we confident enough to ensure best execution to an algorithm while not fully understanding the client or portfolio manager’s fundamental intentions, even including HFT firms and market makers?

Strategy Construction
Most traders will understand dynamics around spotting and sourcing liquidity in the market, but they must also be familiar with the tenets of financial strength (Altman Z, Beneish M and Piotroski F Score), value metrics and sector weight. For example, traders need to track the sector performance to correctly weigh order sizes for each trade they need to execute.

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Besides these fundamental investment concepts, traders should also have a deeper understanding of the technical analysis that their algorithmic strategies are built on, to help them determine realistic targets, safety stops and also validate momentum.

A good example of a skill manual traders know well, but not all electronic traders know is harmonic ranges. Each instrument and its timeframe display habitual movements, which are especially visible using a price bar instead of a traditional time bar. Finding the harmonic range helps a trader determine realistic targets and stops. Typically, a trader would attempt to enter in a new range on the early pivot and target two-thirds of the remaining move. The stop may be placed slightly outside of the range at the point of range violation.

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Knowing the position of your trend is also another basic, yet overlooked aspect. A trend is simply a general direction, which the price is developing or changing. Traders can confirm the trend on the second point and attempt to enter on the second higher low (long entries) or lower high (short entries) and on each consecutive point thereafter. Trend analysis is important because certain algorithms can overreact in choppy markets, making inopportune entries, and traders must understand the trend in the signals the algorithm is processing.

This naturally brings us to momentum. Momentum oscillators are another favourite tool of manual traders, which are calculated from the price movement. Some complex momentum calculations will only attempt to make the oscillator more sensitive or lagging depending on the desired behaviour of the strategy.

These indicators are only useful to help traders gain confidence to execute the trade. A momentum indicator is a small but useful validation to help a trader time their trade entry.

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Fully Automated and Semi-automated
At our firm, we believe in mixing the best of electronic execution and human insight. Below is my trading chart, including our proprietary banding and momentum oscillator tools. We use these to identify the changing trends and price speed when entering trades. Using simplified tools allows our traders to focus primarily on trade management, position sizing and market speed.

Fully automated systems are useful for arbitrage and marketing making strategies, but require a large budget for infrastructure and development. Semi-automated systems have a much smaller budget, but require trader discretion to execute a trade efficiently in the chosen direction. Both systems provide distinct advantages, however, experience has shown that a semi-automated system in the hands of a talented trader will outperform purely automated strategies. A semi-automated trading tool paired with a talented trader brings the best of technology and human talent that will always outperform each element trading on their own.

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The image above is the semi-automated tool that we use, which includes the sophisticated institutional metrics and options that professional traders desire, but it has been further simplified so the trader only needs to focus on the direction they want to enter. Once the trader confirms the trend direction, the tool will attempt to enter at the next most advantageous price range and handle all the position management.

Each member of our trading team specializes in different areas of analysis, but all agree that the basic trading foundations maximize our performance. Only by blending the skills and technical understanding of manual traders with the programming and quantitative abilities of modern algorithmic strategies can today’s traders provide the best returns for their clients and their firms.

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