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What Is Systematic Trading?

Systematic trading is for investors who put their faith in a methodical system for success. This is the trading style you’ll find at a hedge fund. It involves using a system of clear-cut directives for investing. For traders to capitalize on a position, it needs to meet all the criteria of the system. 

This process is often automated. Programs qualify the market conditions for a position entry, then determine the ideal exit point based on technical factors. The decision to enter or exit a position is never in question, and traders never need to make a judgment call. Instead, the rule- and criteria-based system does it for them. The goal is to capitalize on patterns and take human emotion and judgment out of the equation. 

Learn the process of systematic trading

A Rule-Based Trading Style

Also known as “mechanical trading,” systematic trading aims to be as machine-like as possible. The prevailing philosophy in systematic trades is to “trust the system.” Any deviation from the predefined set of variables creates risk. And hedge funds and other systematic traders use systems with as little inherent risk as possible. For example, the approach can look like this…

  • Using technical or fundamental analysis to define opportunities using specific criteria
  • Analyzing the opportunity to determine possible return on investment
  • Defining a trading strategy that accounts for the momentum of the security
  • Simulating the strategy with all costs and risk controls involved
  • Applying the strategy using appropriate stop-loss and target price controls.

By the time a systematic trader rolls out their strategy, they should have clear expectations for it. They shouldn’t need to think about the trades themselves. Instead, they should be able to layer the strategy over the specific opportunity at hand. When a security meets A, B and C criteria, traders open a position. It’s as simple as that. And, because the system includes an exit strategy, they’ll have X, Y and Z controls in place to safeguard them. 

Systematic Trading vs. Discretionary Trading

Where discretionary traders rely on their technical abilities, systematic traders put stock in their system. In many ways, this is the same type of approach, just at different levels. Discretionary traders make case-by-case decisions for their trades, which can introduce variability to a system. Because systematic traders don’t deviate from their system, it becomes easier to, over time, create a system that works consistently. 

Many passive traders prefer systematic trading to discretionary trading. Discretionary traders have the ability to adapt and change their risk controls – for better or worse. While this can result in larger profits, it also opens the door to bigger losses. 

The Benefits of Systematic Trading

With decision-making virtually removed from the process, there’s less risk. Systematic traders can’t second-guess themselves. They can’t get overzealous about a trade or greedy in taking profits. Because they’re bound to the rules of their system, there’s no room to go awry. A good system can produce repeatable profits with few losses.

Consistency and repeatability are big draws for system-based trades. If you take the time to develop a system, you don’t need to consistently evaluate positions. Because systems rely on technical variables, they’re repeatable. It’s easy to pattern trade over any length of time on a system that’s technically sound. Traders can even program systems into automated software to quickly identify and capitalize on opportunities. Repeatability adds up in profits: Both money and time are saved.  

Systematic trades are also considered “safe.” While there’s no sure thing in stock trading, risk is thoroughly evaluated and removed from systems before they’re deployed. This is much of the reason they’re employed by hedge funds. 

Systematic Trading Drawbacks

Inflexibility is the biggest drawback. No pattern is perfect, and the market can become irrational. When the criteria that govern a system fall apart, traders are stuck taking the loss with their built-in safeguards. This is in contrast to discretionary traders, who can adapt to exit their position early if technical analysis shows disruption. There’s no room for a “gut feeling” in systematic trading, even if it turns out to be right. 

The other downfall of systematic trading is the complexity of many systems. Often, they’re not governed by one or two variables, but rather by a whole host of them. Traders need to build their systems with criteria that are strong enough to be successful, yet loose enough to identify investment opportunities. A system that’s too narrow won’t apply to any pattern. One that’s too loose will falter and fail due to volatility

To develop a system, traders need great technical analysis skills and the confidence to create, test, deploy and refine trading strategies. A system can be useful, but only if it’s sound in fundamentals and criteria. 

The Bottom Line

Systematic trading works if your system is tight. The right set of variables and conditions can lead to big profits. And it can even help avoid losses. That said, it’s important to remember that no system is foolproof. The market can become irrational. When it does, patterns fall apart and systems fail. Systematic traders need to have confidence in their system and recognize flukes for what they are. 

Therefore, it’s important to do your research. And the experts at Trade of the Day are here to help. Sign up for the Trade of the Day e-letter below for instant access to stock tips and analysis.

The biggest thing to remember about systematic trading is that it requires trust. Unlike discretionary trades – where the power is in the hands of the trader – systematic trades are rule-based. Traders need to be okay with attributing their profits (and losses) to their system.


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