“We need our trading strategies to adapt to the market to maintain their effectiveness!”
What does that statement mean and how do we achieve it? For our trading strategies to adapt to the markets, they need to have adaptive components.
Defining Adaptive Components
Adaptive Component: A component in the trading strategy that adapts to market conditions.
Adaptive components could be in any part of the trading strategy – entries, exits and position sizing e.g. signal generating rules, indicators, take profit and stop loss etc). Let’s look at some examples to get a clearer picture.
Example of Non-Adaptive Components (Not Good!)
- Hard stop of 100 pips
- Enter a trade when market is 50 pips above yesterday’s high
- Enter 1.5 standard lots per trade
Example of Adaptive Components (Good!)
- Hard stop of 2 ATR (adapting to volatility)
- Enter a trade when market breaks 20-day high (adapting to market range)
- Risk 1% per trade (adapting to account balance)
Importance of Adaptive components
We want our trading strategies to adapt to market conditions to maintain their efficiency. Efficiency is defined as the ability to capture market inefficiencies.
Let’s look at a case study of a component adapting to market range:
- Fig 1: Non-adaptive mean-reversion strategy.
In the scenario above, we have a non-adaptive entry rule. We short at the top red line and long at that bottom red line. This rule works well between time = 0 and time = 1. As the market behaviour changes, the strategy is unable to adapt.
The aim of this strategy is to capture mean-reversion tendencies, but it fails to do that between time = 1 to time = 3. Between time = 1 and time = 2 it does not capture any trades. Between time = 2 and time = 3 it has a tendency to enter some of the trades too early.
- Fig 2: Adaptive mean-reversion strategy.