Types of Strategies that Don’t Work

Are you frustrated with trading strategies that always seem to fail? Do you keep looking for the perfect trading method and end up disappointed? You’re not the only one. Many traders struggle with strategies that don’t work well. It can be tough and even costly. But, there is a way out. By knowing the downsides of some strategies and choosing better methods, you can do better in the market.

In this blog, we will discuss why some trading strategies may look great on paper but don’t work as well in real life. This is especially important for new option traders. When you practise trading with the AlgoTest, you might notice your live trades don’t always match your backtest reports. That’s okay! They can never match 100%. But there are ways to improve your strategies so that your live results can align with your backtest logic. Let’s dive into the top seven mistakes traders make and how to avoid them.

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1. Deep ITM Strikes

What Are Deep ITM Strikes?

Deep ITM (In The Money) strikes are options with prices that are far below (for calls) or above (for puts) the current market price. These strikes have a wide bid-ask spread.

Why Don’t They Work?

• Wide Bid-Ask Spread: The bid-ask spread is the difference between what buyers are willing to pay and what sellers are asking for. Deep ITM strikes are often widespread, which means there’s a big gap between the buying and selling prices.
• Low Liquidity: Not many people are trading these options, so it can be hard to buy or sell them at a good price.

Backtest vs. Live Trading

In a backtest, it always assumes that you got the best price, but in live trading, you won’t necessarily get the same price. Your executed price in live trading depends on several factors, such as bid-ask spread and liquidity. When you trade in deep-in-the-money (ITM) strikes where liquidity is low and the bid-ask spread is wide, your executed price can be significantly different from the backtest price, leading to variations between backtest and live trading results.

Solution

• Avoid Deep ITM Strikes: Don’t trade beyond ITM1/ITM2. Stick to options with higher trading activity and narrower spreads.

2. Small Stop-Loss and Targets

What Are Stop-Losses and Targets?

A stop-loss is a point where you buy/sell to prevent further losses. A target is a point where you buy/sell to take your profit.

Why Don’t Small Ones Work?

• Frequent Hits: If your stop-loss or target is too small, such as 1% or 2%, it can be triggered too easily by small market movements within seconds, resulting in high slippage.
• 1 Minute OHLC Data: The Algo Test uses 1-minute data for backtesting. If the price hits your stop-loss within that minute, but the closing price of the 1-minute candle is in your favour, the backtest might not show it as a loss. However, in real life, you would have sold.

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Backtest vs. Live Trading

Backtesting operates using 1-minute Open, Low, High, Close (OLHC) data. If your entry and exit occur within the same 1-minute candle, such as in a Momentum/Range Breakout Strategy, the back tester may not be able to differentiate whether your entry or stop loss (SL) occurred first. In this case, it checks the close of the current candle. If the close is in your favour, it assumes that your SL was not hit. If the close is not in your favour, it assumes that your SL was hit at the close price. In a live market, your SL will be triggered as soon as the condition is met. This may result in a difference if you are using small stop loss and targets.

Solution

• Use Wider Stop-Losses: Aim for at least 15% to avoid being stopped out by minor fluctuations.

3. Small Momentum

What Is Momentum?

The momentum feature is used to enter a trade when the market moves a certain percentage or points in our direction. It is used to identify trends.

Why Doesn’t Small Momentum Work?

• Multiple Triggers: If your entry conditions are too tight (like 1% to 3%), you might get too many signals to buy or sell in a short time. This can mess up your strategy because the market can move quickly.

Backtest vs. Live Trading

Using a small momentum of 2-3% may not be effective in live markets, as the options can move 4-5% or more in a second. This means that using a very small momentum can result in high slippage in live markets. In backtesting, it assumes that you got the best price, so there can be differences in entry and exit prices, which results in variations between backtest results and live trading.

Solution

• Use Higher Momentum: Set your momentum conditions at least 10% to avoid too many entries.

4. Aggressive Trailing Stop-Losses

What Is a Trailing Stop-Loss?

A trailing stop-loss moves with the market price to protect your profits. If the price goes up, the stop-loss goes up too, but if the price falls, the stop-loss stays where it is.

Why Don’t Aggressive Ones Work?

• Frequent Stop-Outs: If the trailing stop-loss too tight, like 1-2, 2-5, 5-10 where the first value is lower than the high value, you will mainly use it in scalping while doing discretionary trades, but it may work differently in backtest vs live which may cause some difference in backtest and live.

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Backtest vs. Live Trading

Tight TSL works differently in backtest and live. Let’s see how it works.

Assume you have created a trading strategy that involves the following parameters:

– Time: 09:20

– Premium: 100

– Action: Buy Call

– Stop Loss (SL): 10 points

– Trailing Stop Loss (TSL): 1-10 (Where x > y)

Here’s how it works in live trading:

The algorithm will buy a Call (CE) option at 09:20 for 100 with a Stop Loss (SL) set at 90. If the Last Traded Price (LTP) reaches 101, the Trailing Stop Loss (TSL) will be adjusted to 100. If the LTP reaches 102, the TSL will be adjusted to 110. Once the TSL exceeds the LTP, the order will be executed instantly at the LTP, which in this case is 102 in the live market.

Here’s how it works in backtesting:

The backtest operates on 1-minute Open, Low, High, and Close (OLHC) data. It trails the SL based on the High/Low of the 1-minute candle. For example, if you buy a CE option at 09:20 for 100 with an SL at 90, it will then check the high of the next 1-minute candle, say the 09:21 candle, to trail the SL. If the 09:21 candle opens at 101, reaches a high of 110, a low of 99, and closes at 108, and the market moves 10 points in your favour, your TSL will be set at 200. If your TSL exceeds the close price (108), the order will be executed at the candle’s close price, which in this case is 108 in backtesting. This may cause a difference in execution compared to live trading.

It is advised to use this feature only if you have a solid rationale for doing so. For instance, if you are a scalper discretionary trader and you want to actively adjust your stop loss, then this feature may be suitable for you.

Solution

• Avoid Aggressive Trailing Stop-Losses: Make sure the first value is not lower than the second value. Always use the first value higher than the second value in the TSL option.

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5. Too Many Re-Entries

What Are Re-Entries?

Re-entry refers to the act of buying or selling again after your initial trade has been exited.

Why Don’t Too Many Re-Entries Work?

• Slippage Disaster: Every time you re-enter a trade, you face slippage, which is the difference between the expected price and the actual price. As the number of re-entries increases, your slippage also increases, affecting upcoming entries and exits. This can result in differences between backtest results and live trading.

Backtest vs. Live Trading

It’s important to keep in mind that backtesting assumes you always achieve the best price, whereas in live trading you are likely to experience slippage each time you enter a trade. Therefore, if you have multiple re-entries, this means that in backtesting, every time you get the best price, while in live trading, you will experience some slippage, which can affect your stop loss and subsequent entries. This compounding effect could be a reason for the difference between backtesting and live trading results.

Solution

• Limit Re-Entries: Try to keep re-entries to a maximum of three or four times.

6. Tight Data Points

What Are Data Points?

Data points are specific instructions, such as stop-loss, target, and trailing stop-loss, that you input into your strategy.

Why Don’t Tight Ones Work?

• Unrealistic Targets: Very tight data points, like a 100 rupees target or stop-loss, are not practical. For example, in Nifty options, 100 rupees is just a four-point move, which can happen very quickly and frequently.

Backtest vs. Live Trading

When trading in a live market, using small profit and loss targets such as 100rs or 50rs which can hit in 2-3 seconds, can result in high slippage as they can be hit within a very short time. On the other hand, in backtesting, it’s assumed that you receive the best price without any slippage. Therefore, there may be discrepancies between backtest results and live trading if small data points are used.

Solution

• Use Higher Targets and Stop-Losses: Set more realistic goals to avoid frequent triggers.

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7. Candle Close

What Is Candle Close?

In AlgoTest, the back tester uses a 1-minute candle close price to calculate various features, such as overall settings, momentum, ASAP, underlying stop loss/target, etc. AlgoTest also provides this feature for live execution to align with backtest logic.

Why Is It Important?

• Similarity to Backtest: In Backtest, some feature works on candle close. So to align with the backtest result it is important to use candle close in execution too.

Backtest vs. Live Trading

It is important to note that during backtesting, the back tester utilises the 1-minute candle close price in its calculations for certain features such as Overall settings, Re-Asap, and Re-Momentum. If your strategy relies on these features but does not consider the candle close in execution, there may be discrepancies between the backtest results and live trading. Click here to learn more about this feature.

Solution

• Use Candle Close: You can use the candle close feature to align with backtest logic in execution settings.

Additional Pointers

If you’ve read this far, you are serious about trading! Here are some extra tips to help you improve:

1. Use Slippage Estimates: Start with 0.5% to 1% to account for the difference between expected and actual trade prices.

2. Correct Execution Settings: Make sure you use the right settings for your strategy. Click here to know the correct execution settings.
   
3. Remember Ideal Prices: Backtests assume you get the best prices, but live markets have slippage. Always account for this while matching backtest with live.
4. Avoid Curve Fitting: Don’t make your strategy too perfect for past data. Use tools like the Monte Carlo drawdown simulator to ensure your strategy can handle different market conditions. Click here to learn about how to use Monte Carlo simulations.

Now, we’ll dive deeper into some additional tips and tricks to help you improve your trading strategies and make them work better in live markets.

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Additional Tips for Successful Trading

1. Use Slippage Estimates

What Is Slippage?

Slippage is the difference between the price you expect to trade at and the actual price you get. This happens because the market moves quickly, and by the time your order is filled, the price may have changed.

How to Use Slippage Estimates

• Start Small: Begin with an estimate of 0.5% to 1% for slippage. This means if you plan to buy an option at 100 rupees, expect to buy it at 100.5 to 101 rupees.
• Adjust as Needed: If you notice your trades are consistently slipping more than this, adjust your estimate higher.

2. Correct Execution Settings

Why Are Execution Settings Important?

Execution settings are the settings that give you flexibility in order execution type. Using the correct execution settings can make a big difference in your live results. Therefore, it is equally important to use the correct execution settings to maximize results.

How to Choose the Right Settings

• Research and Learn: First you need to understand how each feature in execution settings works. To know about that click here.
• Best Execution Settings: To know the best execution settings for your strategy you can watch a video uploaded on our YouTube channel.

3. Remember Ideal Prices

What Are Ideal Prices?

In backtesting, the system assumes you always get the best price for your trades. This isn’t realistic in live trading because of slippages and market conditions.

How to Account for This

• Include Slippage in Backtests: Always factor in some slippage when backtesting to get a more realistic picture of your strategy’s performance.
• Adjust Expectations: Know that in live trading, you might only sometimes get the ideal price.

4. Avoid Curve Fitting

What Is Curve Fitting?

Curve fitting is when you make your strategy too perfect for past data. It works great in backtests but fails in live markets because it can’t handle new situations.

How to Avoid Curve Fitting

• Use In-Sample and Out-Sample Testing: Test your strategy on different sets of data to see if it works well in all conditions. To learn how to use the in-sample and out-sample features click here.

• Monte Carlo Drawdown Simulator: Use this tool to get an idea of how much drawdown your strategy may face in case of the worst case. To know how to use Monte Carlo drawdown click here.

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Practical Steps to Implement

Step 1: Start with a Logical Strategy

Begin with a logical strategy and test it thoroughly. Make sure it works well in backtests before moving to live trading.

Step 2: Monitor and Adjust

Keep an eye on your live trades and compare them to your backtests. Compare your results weekly or monthly. If you get a big difference, analyse trade by trade with backtest and know the reason. Then work on the reason and rectify the strategy as per the backtest logic.

Step 3: Gradually Add Complexity

Once you’re comfortable with your basic strategy, start adding more elements. Test each change to see how it affects performance.

Real-Life Example

Let’s say you’re trading Nifty options. You decide to use a strategy with a 15% stop-loss and a 30% profit target. Here’s how you can apply the tips from this blog:

1. Avoid Deep ITM Strikes: Choose options that are closer to the current market price.
2. Use Wider Stop-Losses: Your 10% stop-loss is a good start. Make sure it’s not too tight.
3. Higher Momentum: Ensure your entry conditions are not too tight. Use at least 10% momentum.
4. Avoid Aggressive TSL: Don’t set your trailing stop-loss too close. Give it some room to move.
5. Limit Re-Entries: Keep your re-entries to a maximum of three to four.
6. Use Realistic Data Points: Set practical targets and stop losses.
7. Understand Candle Close: Learn how candle close in execution settings works to better execute your trades.

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By following these steps and tips, you can improve your trading strategies and make them more effective in live markets. Here’s a VIDEO, you can check out for more information. Remember, trading is a journey. Keep learning, testing, and adjusting to find what works best for you.