Investing into a trading program - things to consider

Investing into a trading strategy is not always easy. An investor must judge the trading strategy against his own mental profile, and he must be able to come up with a realistic expectations. The wrong strategy will lead to frustration when a normal drawdown will make him fear permanent losses.

Investing into a trading strategy – a leap of faith

This is the core question when investing into a trading strategy. There are tons of crooks around. Tons of people sending emails and selling a new strategy every other week. Putting money onto the table of a trader – either in cash, when participating in a pool or fund, or in giving him access to your trading account – is a leap of faith.

Trust must be earned. It is easier to trust a trader that is established. But what about a new company? Like Well, technically we are not new – NetTecture is slowly approaching 10 years of operation – but is a new offer. I will take us as example (although we right now do not offer anything to the outside). How can you trust us? It is a leap of faith.

Backtest results – worthless without explanations

As we have shown in a blog post about 8 warning signs of a scam strategy provider – do not trust backtest results. A backtest result must be verifiable – which means more than numbers. See that all trades make sense. Unless trade results are verifiable by a third party, ask for real time or near real time signals for some time to validate that the strategy is real and that the then published results match what you are told. It is too easy to “forget” bad trades in the published trade results – even though it is highly illegal. This must not be a real audit – services like Collective2 can serve the exact same purpose. They do not allow deleting trades.

Also make sure you read the marketing material. There should be enough to convince you that the company behind is realistic in both, expectations as well as their business attitude. We publish this blog here for example (and soon web pages with more information) which gives an insight into how we approach the market, what infrastructure we use. This is highly different from someone outing up a website saying “hey, here is a strategy, now give me money”.

There should also be decent expectancy graphs and a good explanation of how risk control is working. Trades should be valued against this expectancy – rating weeks on how good / bad / likely they are. Yes, this is some work. The trader should be willing to answer questions up to the point of disclosing his own secrets – because, with all respect, as investor into a trading program you are not buying the strategy secrets. Obviously common sense should prevail – if you invest 50k USD or less you cannot expect the trader to spend days answering the same questions he already explains on the website over and over again.

Core parameters, though, of risk and strategy review should be available and unless you invest in a strategy that has not traded, regular update newsletters should be available and published on the website.

Besides trust you must ensure the strategy matches you

This is a very core principle. Make sure you understand the risk and trading parameters. Make sure you can actually handle them, mentally. Drawdown is a fact in trading, and both drawdown and recovery behaviour can be mentally stressing. A trader should provide a cheat sheet for his strategy, explaining in non-statistical terms how bad things can be during normal operation. Not to scare you – but you have to sit down as investor and think whether or not you can handle this. Investing 100k USD to see a 25k drawdown come may be brutal mentally – but also be a sign of an aggressive strategy and totally within the acceptable risk parameters. If you quit then not only to you lose a chance for recovery, you do so because you were not prepared for this trading style to start with. Many people ignore this part of their mental setup – only to then have stress problems once bad numbers start coming. And they will come – because, as I said, a drawdown is a core fact of trading. Greed is good, but when greed puts you into a position where fear takes over – money will be lost and it is not the trader or signal provider that is to blame.

A good or more stablished trading outfit will have multiple trading programs – often the same program just with different risk profiles – that you can participate in. Make sure you really get accustomed to what the risk parameters can mean in practical terms.

Once invested, make sure the communication stays active

It is a bad sign if the communication breaks down once you have invested. Obviously – there will be less new information coming. Obviously the trader will not expect to answer tons of questions on the program. But trading information should be flowing. Regularly.

At Trade-Robots we work in weekly intervals – we have ingrained this into our software – for example our backtest analysis always runs in weekly intervals for technical reasons, from Sunday to Saturday. Once we start trading for customers, we plan to not only publish trade updates in regular intervals (you can name this as daily under normal conditions) automatically, but also to provide account and strategy updates every week. These will be mostly automatically generated – but they will be the same review we get on our table to take actions. They will rate trading programs and strategies against their expectation and provide honest review to our investors.

While I know that many other trading signal providers do not provide or plan to provide such a direct communication (a shame, it is 2014, the time of social networks and the internet), at least quarterly reviews should be normal. One should not compare the classical CTA with an automated trading program, though – no automated trading provider will be able to provide a market outlook. He also does not care – he can only say “we saw an increase in volatility which is putting stress on some of our models” but not “we expect the US Stock market to move up” – because he is busy maintaining and developing mathematical models, not predicting the market. As investor, you will have to deal with this – it is fundamental to automated trading.

When the drawdown period comes, make sure you stay calm

I cannot overemphasis the importance of this. It is said that most investors into automated trading programs lose money – not because the program is bad, but because they cannot handle the drawdowns that are normal and that they signed up for. They invest, then remove the funds once a drawdown happens – to move on to the next program. They expect a steady curve up. It never happens. Every program has bad periods. The question is not only how they are monitored, how they are controlled, whether the signal provider takes necessary steps to avoid too brutal losses. They are also a question not how the investor handles the investment.

At the end – you invest into human capital, not computer software

This sounds wrong, but it is the fundamental core. While you do invest into an automated trading program or signal service, the real investment is not with the program code, it is with the person or team behind it. He, she or they come up with the algorithms, do the oversight, do the fine tuning or stop them from trading when market conditions go out of parameters for a strategy. Taking the obvious criminal aspect of a trader stealing money out of the fact, you still invest into a human (or group of humans) and have to trust him. Him and the products he sell, which you need to understand well enough to be comfortable with the risk parameters. And being comfortable really means being comfortable in this place, not pretending to be comfortable. The4 later is the fastest way to lose money when infesting into a trading program.