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Is Your Trading
System Designed for You?
By Darrell
Jobman
(Editors Note:
There are two types of traders: discretionary traders and system
traders. In this issue devoted to system trading, our author
provides an overview of what system trading is all about. When
shopping for a system, there are many key variables that must be
examined if one expects to produce the same type of profits that
have been advertised. This story will set beginning system traders
on the right path to evaluate potential systems.)
Trading systems
seem to be a magical lure for many traders, whether they are
beginners attracted by a promotion piece’s promises of huge profits
or they have been trading long enough to realize they need some
help. After all, what could be more appealing than having something
that tells you exactly what to do to make big money without much
effort? Every trader’s goal seems to center on finding the perfect
trading system. But first we must dispel the idea that there is a
Holy Grail that guarantees success in trading, no matter what the
hype might suggest.
“There is no single
right answer regarding the viability of trading systems for
individual traders – ‘Different strokes for different folks,’ as the
saying goes,” notes Jim Wyckoff, senior market analyst for
www.TradingEducation.com. “However, one universal response to anyone
looking for opinions about buying a trading system is this: Don't
spend hundreds or thousands of dollars purchasing a trading system
and think you are on your way to Easy Street. It is always a risk to
put all of your eggs in one trading system basket.” That is not to
say that trading systems do not work. The big question, however, is
whether the system you select will work for you. That may depend as
much on what you bring to the system as what the system offers to
you.
What Is a ‘System’?
A mechanical trading system generates
precise buy/sell signals based on a specific set of rules and
conditions – the “if this, then that” pattern familiar to most
computer users. The system may have many parameters or only a few,
but whatever the structure, discretion is not part of the
decision-making process. Every trade is prescribed by the system’s
established criteria, which have been researched and tested to
produce the best results. In a black box system, the parameters are
not revealed; in a gray box system, the parameters and logic may be
known but are not changeable. If the parameters can be altered, the
result may lead to the development of a trading system or strategy,
but the program may be better described as an analytical tool rather
than a trading system.
Many trading
systems are trend-following – the premise is that a trend in place
will continue, and the parameters are designed to identify these
trends, hopefully in their early stages. Other trading systems are
based on detecting market reversals – the assumption is that a
market is likely to revert to a central point after deviating to an
extreme in a trading range or price channel. Candidates for trading
systems include newcomers to trading who want exposure to a market
but do not know much about the market or its trading instruments,
traders who have floundered on their own and would like to rely on
more professional methodology, or even successful traders who are
trying to diversify into another trading strategy.
Why Systems ‘Succeed’
Whether you purchase a trading system
or develop one of your own, they do offer several significant
advantages to the trader. Here are a few:
-
Takes the
emotional element out of trading. Each trade is based on a
specific set of rules and does not depend on subjective
second-guessing and the usual fear/greed concerns. Emotion can
be the worst enemy of any trader; a system that takes that
aspect out of picture may be quite useful for that reason alone.
-
Brings
discipline to trading. A well-tested system gives you
confidence to take every trading signal required by the system’s
rules, even though a position may not seem logical. There is no
cherry-picking to select only the trades that seem “right” and
no fretting about what expert analysts are thinking or what the
talking heads are saying to discourage you from taking the
trade.
-
Allows you
to back-test the parameters and rules over an extensive
database. A system that has been developed and tested
properly gives you a good idea of how it might perform in the
future before you have your money on the line in real-time
trading. Because everything in a system is quantified and there
is no place for hindsight, you have some actual numbers on which
to make a judgment about the value of a system or how to
fine-tune it to get more acceptable numbers. You can optimize
the best criteria for entry, exit, stop placement, etc. to
discover what produced the best results on past price history.
Why Systems ‘Fail’
Even though trading systems have many
advantages, they do have some inherent limitations. Much of the
concern revolves around track records and the hype in hypothetical
trading, which may be misleading to the unwary system buyer. It is
for good reason that the Commodity Futures Trading Commission and
National Futures Association require phrases such as “past
performance is no guarantee of future success” or words to that
effect on material related to trading. But when a trading system
doesn’t perform as expected, the fault often lies more with the
trader than with the system. Here are some things you should check
to see if you are a good match for the trading system you are
considering:
Logic of the
system. The vendor is not likely to reveal the exact parameters
of a proprietary trading system, but it’s a good idea to have some
sense of the system’s approach to trading. Do you need to know a
system’s exact parameters? Probably not, but one important factor in
using a trading system is to build confidence in it. For many
traders, that requires some knowledge of what is happening under the
hood.
Performance
report. One thing that should be stressed is that back-testing
software, no matter how good it may be, may not give an accurate
report of actual trading results. For example, most testing software
cannot tell whether the high or low of a price bar occurred first or
whether a signaled order at a given price was actually able to be
executed at that price due to gaps, fast markets or other real-life
trading situations. You may have been stopped out of a position or
gotten into a position, but the software relying on the system’s
rules may record it as a big profit or small loss that is not what
your account statement shows. The bottom line is that performance
reports are good for making comparison, but it is unlikely a system
will ever perform exactly as the back-testing software indicates.
Track record
time period. Is the track record based on a period that was
particularly favorable for the system’s approach? You may see a
track record for a stock index system based on the bull market of
the late 1990s or the bear market of 2000-2002 or the bull market of
2003-2005. But does this system hold up in all types of market
conditions, especially what’s happening currently? Check the trade
history dates carefully.
Net profit.
Of course, profit is what a trading system is all about and is the
first filter for most traders looking at a system. If a system
doesn’t show a nice profit, it’s not worth much attention. But
profit isn’t the whole story, as many other factors need to go into
selecting a trading system.
Number of
trades. You may not care how many trades it takes to generate
profits, but your profits, but commissions, fees and slippage may
eat up your profits if the system makes too many trades. You can
live with these costs if the profit is large enough, but if costs
are not included in a performance report, they can be a big factor
in a marginally profitable system.
Pulling the Trigger
Who will trade the system? Will you be
trading the system yourself or will you let a broker trade the
system automatically? Depending on the number of trades the system
makes, it may not be practical for you to manage a day-trading
system that requires frequent trading. But are you comfortable
letting someone else handle your trading?
More Factors to
Consider
Percent of
winning trades. Many traders regard the percent of winning
trades to be very important, but it is possible for a trading system
to be profitable even when the number of losing trades exceeds the
number of winning trades. For the purposes of instilling confidence
in a system, however, it would naturally be preferable to have more
winners than losers, but that is not so critical as long as the
winners are large enough.
Average profit
per trade. If a system trades frequently and the average profit
per trade is relatively low, the system may not be worth the effort
to trade. Commissions and a few bad fills can soon eat into whatever
profits you do earn.
Maximum
drawdown. After profit, the next place most traders look on a
performance report is the drawdown figure. That’s because a trading
system with the most promising profits may have severe setbacks
along the way – those periods when the number of losing trades or
the size of the trading losses is so great that the trader can no
longer take the pain and abandons the system. What is your tolerance
for loss? Would you rather have a 100-percent gain with a maximum
drawdown of 31 percent, or would you be more comfortable settling
for a 70-percent gain with a maximum drawdown of 9.4 percent (see
Figure 1).
Amount of
capital. Most traders who lose probably do so not because of
their trading system but because they are undercapitalized to trade
the system as it was designed to be traded. Let’s say you buy a
highly touted trading system for $3,000 that is guaranteed to
produce profits if you trade the system exactly as intended. The
system trades ten markets, several of them high-margin contracts
that you have never traded before, and requires an account size of
at least $50,000 to take all of the recommended trades.
Unfortunately, you only have $25,000 in your account (mistake number
one). So you decide you will have to pick the markets and the trades
you will take (mistake number two).
It Takes Money
The system has had
an admirable track record, according to the salesman, but after you
buy it, the first six trading recommendations in a row are losers,
wiping out half of your trading account. Your confidence in the
system vanishes despite the vendor’s reassurance that such a large
drawdown has never happened before. You give up on the system after
a month or two, and you can bet that two things will happen: (1)
Your guarantee will be null and void because you didn’t follow all
of the system’s recommendations; and (2) as soon as you quit trading
it, the system will have a streak of winning trades. Even the most
successful trading system requires money to make money. (I know
someone intimately who can testify to that scenario.)
Best trade,
worst trade. Look over a trading system’s trading history to
find the largest winning and losing trades. You may find that a
system that reported profits of $10,000 made $8,000 of that gain on
a single trade in coffee, for example. What if you had missed that
one trade? Your performance and the system’s performance might be
far different. Or what if the system’s parameters would have
produced a large losing trade that is conveniently omitted from its
trade history? Check out those days when you know the market’s
volatility might have made a big difference in a system’s
performance – April 20, 2006, for example, if the system trades
silver futures.
Over-trading.
The other side of having enough confidence in a trading system to
take every signal is to have too much confidence in a system so that
you trade larger positions than you should. You may rationalize that
if the system is so good, why not trade larger and make more money
faster? The system may work nine times out of ten, but the one time
it doesn’t may be very costly if you are over committed, which can
lead to blowing out your account faster than almost any other
mistake you can make. Position size is a key element of successful
trading.
Do Your Homework
Today’s computer power makes it
possible to produce all kinds of trading systems to eliminate the
emotional factor in trading, from the sophisticated versions used by
algorithmic traders and financial institutions to the many different
types of mechanical trading systems available to the retail trader.
With some of these retail systems selling for thousands of dollars,
traders have a big stake in determining first whether a trading
system fits their style and then which particular trading system
will best meet their needs.
Darrell Jobman is Editor-in-Chief of
www.TradingEducation.com, which provides free daily and weekly
commentaries for traders. He is an acknowledged authority
on the financial markets and has been writing about them for more
than 35 years.
Source:
TradingEducation.com |
