Automated trading systems can be classified as disclosed or black box and based on the type of algorithm used. Popular algorithms include cycle studies, volatility breakout, and price breakout. Profitable systems are created by experts in physics and market understanding. Caution and research are necessary when entrusting money to automated trading systems.
There are two ways to classify automated trading systems. One is on the basis of whether the algorithms are disclosed. If the algorithms are disclosed, the systems are called a “disclosed system”. Automated trading systems that are not disclosed are called “black box” systems. The second way to classify these systems is based on the type of algorithm used.
Cycle studies, volatility breakout, and price breakout are the most popular algorithms. Cycle studies put together cycles of different lengths to predict tops and bottoms. Volatility breakout systems typically focus on times when a stock or commodity has low volatility, then enters the market with increased volatility. Price breakout systems track the highest and lowest prices over a period of time, then enter the market when a higher or lower high is reached.
After an automated trading system has entered a position, it must determine when to exit that position. Some systems use a moving average, while others hold for a certain number of time periods and then exit. Another approach is to exit as soon as a position is profitable or to exit after reaching a certain level of profitability. Most systems have a fixed amount of loss which is the largest loss the system is designed to allow. The term for that amount is the “stop loss”.
There are many computer programs sold as black box trading strategies. Most of them are sold on the basis of “backtesting”. If there is no substantial real-time trading history, or a large set of good results on data other than backtest data, such as a Monte Carlo simulation, using the system with real money is a big bet. It’s not hard to put together some rules and then optimize the system for five to ten years of trading data so that they produce amazing results, but such a system is unlikely to be profitable in real trading.
There are automated trading systems that are profitable. They have been created by people with a very deep understanding of physics working alongside people who have a very good understanding of how markets work. The creators work for investment or commercial groups that, for the most part, keep a low profile. Like all areas of trading or investing in the markets, entrusting money to an algorithmic and automated trading system should be done with great caution and only after substantial research.
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