System shelf life/discovered systems

Numerous publications talk about the concept of a system ceasing to be profitable simply because it becomes too well known. The theory goes that a profitable system, once discovered by every other trader, will quickly become unprofitable. I am fairly new to system development and I wondered if anyone could shed some light on the reasons why this occurs. Not why people discover systems (that's clear) but how their discovery makes systems unworkable. All the literature I've consulted on this point talks in vague terms e.g. "everyone sees it coming and spoils it for everyone else" or "with so much money taking up the position, the inefficiency is lost" or "the smart money fades the position". If we take a simple system based on long trades on the formation of triangles (let's assume there is a positive expectancy), how does everyone's recognition of a triangle distort the position? If everyone sees the triangle and everyone wants to go long then how has the position become spoilt? Similarly, how do I or how do we (as a market) hope to fade buyers of the triangle? What I was most interested in, in reading the literature, was Alan Farley's "The Master Swing Trader". He talked with much humour of how he sees a pattern developing and waits for all the longs (like lambs to the slaughter) take up a position (i.e. price goes north) before he then fades the position. How does he do that? I could understand fading a position where it's clear buyers have started to lose the initiative but otherwise? Farley says that in the modern era where everyone has whizzbang technology and every Jimmy Trader can spot a basic pattern, small traders' equity is hit hard. Can anyone educate me here to the specific dynamics/market psychology at work? Please reply on the point.
Best of luck to you all for the coming financial year.

Basically, if a system is discovered and disclosed, it is 'arbitraged' out of existance. Obviously, not everyone can profit from a system - someone has to loose.

Try backtesting simple systems such as buy on open when 2 moving averages cross, then sell when they cross the other way. You will be amazed at how randomized the stock market is (otherwise, everyone could profit and arbitrage would occur).

However, VERY long term systems such as Tech/A's techtrader doesn't seem to have this problem.

Great question Bin57again,

Know what the herd is doing then adjust, get your timing right & you will do OK.
I can see where a stock is going ( very short-time ) , but only accurately in a time zone that I can monitor.

Bob.

Just noticed this same sort of phenomenon when watching resistance points. When the price breaks it seems to hammer on through really hard then carry on its merry way regardless. Must be a clash of traders and fundamentals by my reasoning. By rights one should buy on breakout and carry very short stops. Of course liquidity comes into play here as well.

I have seen a real time example of a trading system being "arbitraged out". Roger Montgomery relaesed a Hang Seng trading system several years ago. Whilst the system's integrity was flawed to start with (for another thread) the system quickly deteriorated due its users.

Basically the system traded an illiquid market which in itself was a poor choice. Then when people started getting entry/exit slippage they decided to buy or sell ahead of the official entry price so they could get set at a better price. This slowly built upon itself until these "frnot runners" were eseentailly triggering the systems signals rtaher than allowing the market itself do it.

I used a Hang Seng System that tended to trade in the same direction as Montgomery's, however we did share the same exit. Because I knew that all his minions were going to exiting at my level I would initiate my exit ahead of theirs, to their detriment and my gain.

Other popular patterns/systems that have now broken down is the Larry Williams Oops! pattern (which in fact was first revealed back in the 50's before Williams was even trading). That pattern simply does not work on major markets anymore. If you do historical testing up until his book "Long Term Secrets to Short Term Trading" was released, you can see that it deteriorated from that point on. People basically front run to beat the crowd.

Another system that has deteriorated is the simple channel breakout created by Donchian back in the early 70's. We know this system now as the Turtle System but such basic breakout systems do not work anymore.

So the moral here is to keep your system silent. Don`t tell anyone.

Mark - please would you explain for me what you mean by arbitraging a system. I understand the term "arbitrage" but not in this context. Does it mean, for example, waiting for a buy price to rise rapidly before going in hard on the short side?
Nick - I can understand OOPS not working which is a very specific technique but a channel breakout? It could be a 5 day or a 20 day or a 50 day? Are you saying that people are monitoring every parameter and trying to fade? Would this also mean people monitor every support and resistance point and look to do the same? Would it be true to say that systems which, for example, trade tops and/or bottoms are similarly unprofitable because everyone sees them?
Thanks to all.

Bin57again said:

Mark - please would you explain for me what you mean by arbitraging a system. I understand the term "arbitrage" but not in this context. Does it mean, for example, waiting for a buy price to rise rapidly before going in hard on the short side?
Nick - I can understand OOPS not working which is a very specific technique but a channel breakout? It could be a 5 day or a 20 day or a 50 day? Are you saying that people are monitoring every parameter and trying to fade? Would this also mean people monitor every support and resistance point and look to do the same? Would it be true to say that systems which, for example, trade tops and/or bottoms are similarly unprofitable because everyone sees them?
Thanks to all.

Click to expand...

Breaks get arbied out not from Fading but from slippage. Say that someone finds that a 20 day breakout is a sure fire winner and that you tend to make 20% off the breakout. It works for awhile and a it gets discovered what happens is that you put a buy stop in at the 20 day high and get heaps of slippage because of all the other orders. Because of the slippage the trade may not be profitable anymore. So you get in early at the 19 day breakout. However, this is not as profitable (otherwise people would already be trading it). Eventually slippage occurs here are well as other people also move to the 19 day breakout ... and so on.

I certainly notice that when a pattern starts to become reliable, it then starts to quickly become unusable for a while.

Whether its because everybody is jumping on that pattern, or fading it, or whatever, I don't know. But it is certainly observable.

...and in the case of Montgomery's system... a publicly sold system where a whole bunch of people are trying to rake the SAME signal is bound to break down.

It doesn't just happen with tech systems either. I believe a similar thing happens with the Rivkin, and similar, reports.

I know somebody who studied Rivkin calls and he found if you waited a week the price would sink back as the initial rush died off.

I subscribed about 7 or 8 years ago. I found that his hit rate was okay but you'd only be making a couple percent on each trade and then he'd turned fundamental and hold onto a losing stock wiping out all of the profits.

MIT

Bin57again said:

Mark - please would you explain for me what you mean by arbitraging a system. I understand the term "arbitrage" but not in this context. Does it mean, for example, waiting for a buy price to rise rapidly before going in hard on the short side?

Click to expand...

I guess I am using the term arbitrage quite loosley here. [ie. A real example of arbitrage might be buying a news paper for $1.50 because it has a cupon to recieve a free meal at maccas worth $5]

As Nick and others implied, I am using 'arbitrage' to describe the situation where everyone tries to use a publically known system - and this tends to raise the entry and drop the exit price (assuming a 'long' system) until there is no net gain.

If the newspaper and maccas markets were sufficiently liquid, what you would find is that all the newspapers would be sold out (increasing thier price on the 'black market'), and the queues at maccas would increase. The original price differential would be nullified by the increased cost of the paper, and your '$ time value' wasted in the maccas queue. So there would be no net benefit from using the system. (ie it has been arbitraged out)