Stocks and Commodities Magazine, July 2006
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:
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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.
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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.
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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
Reprinted from Stocks and Commodities.
Copyright 2006 Technical Analysis, Inc.,
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