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Robert Carver – Systematic Trading – Review

Robert Carver - Systematic Trading - ReviewI’ve been following Rob’s work for quite some time. He is a systematic trend-following trader, who trades different futures markets. He is also very mathematical in his quantitative approach. I decided to read his book about systematic trading to better understand his thought process. It was published in 2015.

Introduction to the topic

Rob has written this book for three types of market participants: asset allocating investors, semi-automatic traders and staunch systems traders. By semi-automatic he means discretionary traders using rules, so I seem to fall into the third camp myself even though I manually place orders into the brokerage platform.

The author focuses much on Sharpe ratio, something that I haven’t found useful myself. Basically, it’s a common metric to measure volatility of a portfolio, subtracting the risk-free rate first from average rate of return and then dividing it by standard deviation of returns. Traders consider it to show the risk of a portfolio but I haven’t found it reliable, because it penalizes strategies with upside volatility, so I consider loss of capital to be the real risk. I like MAR ratio more, which is compound annual growth rate divided by maximum drawdown to date.

Dangers of backtesting and systematic trading

Rob goes through the process of backtesting a strategy and why over-fitting the rules on historical data is the most dangerous pitfall for this type of market participants. He shares some tips on how to avoid it.

Capital allocation and portfolio weights

The author shares different ways how to allocate capital to several trading systems or instruments, also suggesting ideas for portfolio weights. Every asset is measured for volatility and diversification at a portfolio level to consider the risk taken. Rob writes why using a computer blindly to calculate and optimize the allocation weights in a portfolio can often lead to a bad outcome. He goes on suggesting that equal weights may seem too simple, but are actually hard to beat. It may be better and easier to do these calculations by hand. Rob calls it the handcrafting method.

I have actually felt myself that it’s hard to let the computer decide on allocations by the click of a button. I have put some discretion into asset allocation to have a fixed framework I can systematically follow. First, I look at a trading strategy on its own to see how much risk should be allocated to each trade and the overall set of trades open at a time. I then put all strategies and their risk together at a portfolio level to look at the overall risk weights across the strategies. I take volatility into consideration so that more volatile strategies get less capital compared to others with smaller drawdowns. I like to look at MaxDD and regular drawdowns to measure volatility, rather than looking at the standard deviation of returns. Next, I look at correlations between strategies to attack risk with different entry / exit rules, trade direction and timeframes. When the weights across strategies are in place, I keep monitoring it and have slightly adjusted the allocations in time based on observations while trading the system.

Trading in the moment of now

It was annoying to see him use the word “forecast” to describe trading signals. In my opinion, people can forecast the weather, not financial markets. Systematic traders in particular should avoid trying to forecast anything, but just keep executing a system with positive expectancy. I doubt Rob uses that word so much today, so I think this is something to be forgotten to 2015.

It’s all about math

The author shares lots of calculations and examples how to do position sizing and portfolio management. The core principle is managing volatility of the assets in a portfolio. He defines open trade volatility as risk. I don’t look at risk the same way, because to me risk is loss of capital. I don’t want to adjust my positions every day or week based on the price noise. As long as my stop loss hasn’t been hit nor target met, the trade is on with expected fluctuations. I think traders target volatility to feel comfortable and it comes for the price of less returns. Also, the more often one adjusts positions the more it’ll increase trading fees. Rob shares some great wisdom about trading speed and size for a small as well as a large account.

The examples how to calculate the optimal portfolio volatility based on Sharpe ratio and skew gave some understanding about the safe volatility targeting in his world. I have read about the Kelly criterion before, but Rob’s way of using it in volatility targeting shed some light to the mathematical formula for bet sizing. Just like many other investors have said that the full Kelly was too risky, Rob writes about using half-Kelly.

Putting it into practice

In the final part of the book Rob shows how the three different types of market participants (asset allocating investors, semi-automatic traders, staunch systems traders) could put his framework into action. Throughout the book he warns about trading instruments with very low volatility and I see where he’s coming from. Due to volatility targeting these low vol positions would be very large, hence vulnerable to sudden vol expansion.

I got several thoughts from the book about Rob’s approach to systematic trading. Even if I don’t agree with everything he does, it’s useful to understand how different trading styles can be and that everyone is not doing the same thing. Afterall, it’s being unique that usually gives the best edge in a financial market. Rob is mathematical and systematic in his approach and I think this book is not an easy read for a starter. However, if you want to know more about the differences between systematic vs discretionary trading, avoid over-fitting in backtests, learn portfolio construction with Sharpe ratio and volatility targeting, then this book is definitely something to explore.

Systematic Trading by Robert Carver book link

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