One of the biggest challenges to automated trading is that, over time, strategies seem to lose their edge. This effect is often referred to as the the Alpha Decay. But, why would a strategy that has been working for months or years suddenly stop working? Well, the answer is simply that the market changes.
I am not talking about a long term sentiment change, like for example Governments engaging in years of Quantitative Easing or a newly negative outlook for a country, but an actual change in the underlying dynamics of the market.
A pretty obvious example should be the rise of automated and high-frequency trading in the Forex Market as opposed manual trading. While this is hard to qualify due to the off-market nature of Forex, it is undoubtedly taking place. This has a huge impact on the market dynamics now compared to the market 10 years ago, and personally I do not even believe there is any point to back testing on market data from 10 years ago.
However, sometimes the change is not so obvious but can still be significant. An example of such a change is the recent regulation scrutiny in the Forex industry. Big banks are being fined for manipulating rates and inside-trader communications are being exposed no doubt putting pressure on such behavior. These articles are important should not go unnoticed.
With such regulatory pressure going around, the market will tighten up and a particular segment of the market will, more than likely, disappear. Depending on your strategy, this may be a change for the better, or for the worse.
Therefore, as you back-test your strategy over several years of data (as you all should be doing), keep these kind of changes in mind. If your strategy was making good money until recently, then ask yourself why? Has the market changed? Can you find any news that came out in that quarter or year that may indicate a change?
While all strategies will go through periods of loss and draw-downs, sometimes changes can cause strategies to stop working all together. So, if your strategy is no longer working as good as it used to be, perhaps it is time to tweak or abandon your strategy? Think about it.