Is your trading system acting like a predator or prey in the markets? This is an exploration of two hypothetical trading system types. This isn't about who wins and who loses, necessarily. In this thought exercise, both predator and prey can "win." I'm guessing that chances are, even if your system is a winning one, it is a "prey-type" system. CASTrader as it stands now, is a prey-type system.
What is a prey-type trading system? A prey-type system is a system that is developed purely based on historical market patterns and perfected assuming market conditions will not be altered by your actions. You are reacting to market history, hopefully profiting from the patterns the market hands you. If you are working with a small amount of capital, you can happily graze on the profits you find. However, if you overgraze with a bigger bankroll, you may find the very patterns you hoped to profit from are gone. Either they never existed in the first place (due to datasnooping), or you've eliminated them. The pitfalls of backtesting are many, but it is the only logical way to test out a prey-type system. Most testing software I am aware of calculates profits assuming market conditions will not be altered. A prey-type system generates profits from existing unclaimed price patterns.
Ok, what is a predatory trading system. A predatory trading system would be a system that aims to profit from market changes that it induces in the market. On the Grea
t plains of North America, indigenous peoples once guided buffalo herds towards what's known as a buffalo jump. (At left is the appropriately-named "Head-Smashed-In" buffalo jump - image courtesy of Wikipedia). In other words, the buffalo were induced off the cliff by the actions of their predators preying on the behavioral biases of the buffalo. Sane buffalo obviously do not jump off cliffs on their own. A predatory trading system profits from induced price patterns. In other words, it makes a market-moving trade that induces sufficient favorable liquidity to get out with a profit. If the market is a chaotic system, this might be the butterfly effect that you can predict, and thus profit from(Update: PRD has more on Chaos and the financial markets) . Unlike a prey-type system, a predatory system cannot be backtested, at least in the standard way. Conventional backtesting systems that I am aware of do not attempt to measure how your system alters the market. Prey-type backtests are based on the assumption of infinite liquidity, which isn't a bad assumption for small traders. In fact, a perfect backtest could not possibly be performed on a predator system because you cannot possibly know apriori the exact consequences of your actions.
Who are the predators and who do they prey on, exactly? Well, to wring out the last drops of cliche from the predator/prey analogy: the weak, oblivious, or simply unlucky prey. Prey-type systems are numerous and diverse - predators wouldn't capture them all, so some survive, even thrive. Others simply see their profits vanish, greatly reduced, or worse: go negative. It's certainly happened before on a grand scale in other markets with disastrous results for the predators. Naked shorting is predatory, in my opinion. Predator systems at the day-in/day-out level however, if they exist at all, are probably rare, but well-funded. It's pure speculation on my part that such systems exist and are profitable in the stock market, as I am not aware of any. Then again, I don't hang out on Wall Street much. Perhaps market-makers know, since they have the ability to alter the bid-ask, and I'm pretty sure they are well-aware of the many nuances of what happens when they do while they provide liquidity for profit. Maybe the Super Quants have used high frequency predatory algorithms. When a quantitative fund can account for 10% of all the transactions on the NASDAQ in a single day, would you guess they are using prey-type or predator algorithms? Maybe some traders simply do it in their heads by looking at the order book. Are you predator or prey? If you are prey, are you being hunted and are you nimble enough to escape?
Update: Move the Markets offers more perspective in You actually do move the markets.
Comments