Automated trading systems can be classified as disclosed or black box, and based on the algorithm used. Popular algorithms include cycle studies, volatility breakout, and price breakout. Exit strategies include using a moving average or exiting after a certain level of profitability. Many black box trading strategies are sold on a backtested basis, but profitable systems are created by experts and should be approached with caution.
There are two ways to classify automated trading systems. One is on the basis of whether or not the algorithms are disclosed. If the algorithms are disclosed, the systems are called a “disclosed system”. Automated trading systems that are not disclosed are referred to as “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 combine cycles of different lengths to predict highs and lows. Volatility breakout systems generally focus on times when a stock or commodity has low volatility, then enters the market with increased volatility. Price allotment systems track the highest and lowest prices over a period of time, then enter the market when a higher high or low is reached.
After an automated trading system enters a position, it must determine when to exit that position. Some systems use a moving average while others hold it for a number of time periods then exit. Another approach is to exit as soon as a position is profitable or to exit after a certain level of profitability has been reached. Most systems have a fixed amount of loss which is the largest loss the system is designed to allow. The term for this amount is “stop loss”.
There are many computer programs sold as black box trading strategies. Most of them are sold on a “backtested” basis. If there is no substantial real-time trading history or a large amount 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 difficult to string together a few rules and then optimize the system over five or ten years of trading data so that they produce mind-blowing results, but such a system is unlikely to be profitable in real-world trading.
There are profitable automated trading systems. They were created by people with a deep understanding of physics working alongside people who have an excellent understanding of how markets work. The creators work for investment or trading groups which, for the most part, keep a low profile. Like all areas of trading or investing in the markets, entrusting your money to an automated and algorithmic trading system should be done with great caution and only after thorough research.
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