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Developing and Implementing Trading Systems


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Developing and Implementing Trading Systems

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Developing and Implementing Trading Systems

Nothing is easier than developing a trading system by the •usual process of trial and terror.


суда) и ужаса(террора). Они подтолкнут) Вас, чтобы определить то, чему Вы верно верите.

систему для торговли. Этот подход увеличит разногласия), что Вы выживете и будете процветать на рынках.

разумном) управлении денег, благоразумном контроле(управлении) риска, и осторожном внимании к выполнению. Эти факторы отличают эту книгу от других

первоначальное или новое. Эта книга разделена на две половины по четыре главы каждая. Первая часть посвящена проектированию торговых систем. Вторая половина обсуждает, как внедрить системы торговли. Первая половина охватывает следующие темы:

Development of trading system variations, which discusses eight variations of known ideas

Once you have read the first half, you will be eager to explore ques­tions about system implementation. The second half of the book is or­ganized as follows:

5. Equity curve analysis, which explores what influences equity curve smoothness

6. Ideas for money management, which is the starting point for risk control

7. Data scrambling, which offers all the synthetic data you will ever need

8. A system for trading, which presents solutions to practical prob­lems

After reading this volume, you should be able to take your ideas and convert them into useful trading systems. This book develops deter­ministic trading systems, which means that all the rules can be explicitly evaluated. The book does not discuss trading systems based on expert systems, neural networks, or fuzzy logic for two simple but important reasons: (1) More users understand and easily implement deterministic systems than any other type of system. (2) The software for testing de­terministic systems is widely available at an economical price. Put the two together, and this book becomes immediately accessible to a large audience.

What Is a Trading System?

The Usual Disclaimer

Throughout the book, a number of trading systems are explored as ex­amples of the art of designing and testing trading systems. This is not a recommendation that you trade these systems. I do not claim that these systems will be profitable in the future, nor that profits or losses will be similar to those shown in the calculations. In fact, there is no guarantee that these calculations are defect free. I urge you to review the section in chapter 3 called a reality check. That section points out the inherent limitations of developing systems with the benefit of hindsight. You should use the examples in this book as an inspiration to develop your own trading systems. Do not forget that there is risk of loss in futures trading.

What Is a Trading System?

A trading system is a set of rules that defines conditions required to in­itiate and exit a trade. Usually, most trading systems have many parts, such as entry, exit, risk control, and money management rules.

The rules of a trading system can be implicit or explicit, simple or complex. A system can be as simple as 'buy sweaters in summer,' or 'buy when she sells.' By definition, the system must be feasible. Ideally, the system accounts for 'all' trading issues, from signal generation, to order placement, to risk control. A good way to visualize effective sys­tem design is to stipulate that someone who is not a trader must be able to implement the system.

In practice, every trader uses a system. For most traders, a system could really be many systems. It could be discretionary, partly discre­tionary, or folly mechanical. The systems could use different types of data, such as 5-minute bars or weekly data. The systems may be neither consistent nor easy to test; the rules could have many exceptions. A sys­tem could have many variables and parameters. You can trade different combinations of parameters on the same market. You can trade different parameter sets on different markets. You can even trade the same pa­rameter set on all markets.

It should be clear by now that there is no single universal trading system. Every trader adapts a 'system' to his or her style of trading. However, it is possible to draw a distinction between a discretionary trader and a 100% mechanical system trader, as compared in the next section.

Developing and Implementing Trading Systems

Comparison: Discretionary versus Mechanical System Trader

Table 1.1 compares two extremes in trading: a discretionary trader and a 100% mechanical system trader. Discretionary traders use all inputs that seem relevant to the trade: fundamental data, technical analysis, news, trade press, phases of the moon—their imagination is the limit. System traders, on the other hand, slavishly follow a mechanical system without any deviations. Their entire focus is on implementing the system 'as is,' with no variations, exceptions, modifications, or adaptations of any kind.

Exceptional traders are discretionary traders, and they can prob­ably outperform all mechanical system traders. Their biggest advantage is that they can change the key variable driving each trade, and therefore vary bet size more intelligently than in a mechanical system. Discretion­ary traders can change the relative importance of their trading variables so they can easily switch between trend-following and anti-trend modes. They can instantly switch between time frames of analysis, going from 5-minute bars to weekly bars as their assessment of the trading opportu­nity changes.

Discretionary traders can make better use of market information other than price. For example, they can react to news or fundamental in­formation to change bet size. Discretionary traders can adjust their per­ceived risk constantly, so they can increase or decrease positions more intelligently than mechanical traders. These infrequent 'home runs' often make all the difference between good and great trading perform­ance. However, for the average trader, being a mechanical system trader probably maximizes the chances of success.

The goals of a mechanical system trader are to pick a time frame (for example, hourly, daily, weekly), identify the trend status, and antici­pate the direction of the future trend. The system trader must then trade the anticipated trend, control losses, and take profits. The rules

Table 1.1  Comparison of trading styles: Discretionary versus mechanical

Discretionary Trader  100% Mechanical System Trader

Subjective  Objective Many rules Few rules Emotional Unemotional Varies 'key' indicator from trade to trade 'Key' indicators are always the same Few markets Many markets

Why Should You Use a Trading System? 5

must be specific, and cover every aspect of trading. For example, the rules must specify how to calculate the number of contracts to trade and what type of entry order to use. The rules must indicate where to place the initial money management stop. The trader must execute the system 'automatically,' without any ambiguity about the implementation.

Mechanical system traders are objective, use relatively few rules, and must remain unemotional as they take their losses or profits. The most prominent feature of a mechanical system is that its rules are con­stant. The system always calculates its key variables in the same way re­gardless of market action. Even though some indicators vary their effec­tive length based on volatility, all the rules of the system are fixed, and known a priori. Thus, mechanical system traders have no opportunity to vary the rules based on background events, nor to adjust position size to match the markets more effectively. This is at once a strength and a weakness. A major benefit for system traders is that they can trade many more markets than can discretionary traders, and achieve a level of di­versification that may not otherwise be possible.

You can create different flavors of trading systems that use a small or limited amount of discretion. You. could, for example, have specific criteria to increase position size. This could include fundamental and technical information. You can be consistent only if you are specific. This discussion really begs the question of why to use trading systems, answered in the next section.

Why Should You Use a Trading System?

The most important reason to use a trading system is to gain a 'statisti­cal edge.' This often-used term simply means that you have tested the system, and the profit of the average trade—including all losing and winning trades—is a positive number. This average trade profit is large enough to make this system worth trading—it covers trading costs, slip­page, and is, on average, likely to perform better than competing sys­tems. Later in the book, I discuss all of these criteria in greater detail.

The statistical edge is relevant to another statistical quantity called the probability of ruin. The smaller this number, the more likely you are, on paper, to survive and prosper. For example, if you have a prob­ability of ruin less than, say, 1 percent, your risk control measures and other measures of system performance are typically sufficient to prevent instant destruction of your account equity.

Developing and Implementing Trading Systems

My biggest source of concern about these statistical numbers is they assume you will trade the system exactly as you have tested it, with not one deviation. This is difficult to achieve in practice. Thus, your risk of ruin—and it is only a risk until it becomes a fact—could be higher than your calculations. Despite this concern, you should develop systems that meet sound statistical criteria, for that greatly enhances your odds of success. As usual, there are no guarantees, but at least the odds, if not the gods, will be on your side.

Another reason to use a trading system is to gain objectivity. If you are steadfastly objective, you can resist the siren call of news events, hot tips, gossip, or boredom. Suppose you are a chart trader and you enjoy some flexibility in interpreting a given chart formation. It is very easy to identify a pattern after the fact, but it is rather difficult to do so as the pattern evolves in real time. Hence, analysis can paralyze you, and you may never make an executable trading decision. Being objective frees you to follow the dictates of your analysis.

Consistency is another vital reason to use a trading system. Since the few rules in a trading system are applied in precisely the same way each time, you are assured of a rare consistency in your trading. In many ways, objectivity and consistency go together. Although consistency is known as the hobgoblin of little minds, it is certainly a useful trait when you are not quite a champion trader.

A trading system gives another crucial advantage: diversification, particularly across trading models, markets, and time frames. No one can be certain when the markets will have their big move, and diversifi­cation is another way to increase your odds of being in the right place at the right time.

In summary, you can use a trading system to gain a statistical edge, objectivity, consistency, and diversification across models and markets. A key assumption underlying this section is that the system you are using is well designed and robust. The next section discusses examples of a ro­bust trading system.

Robust Trading Systems: TOPS COLA

A robust trading system is one that can withstand a variety of market conditions across many markets and time frames. A robust system is not overly sensitive to the actual values of the parameters it uses. It is not likely to be the worst or best performer, when traded over a 'long' time (perhaps 2 years or more). Such a system is usually a trend-following

How Do You Implement a Trading System? 7

system, which cuts losses immediately and lets profits run. This philoso­phy, called TOPS COLA, merely says 'take our profits slowly' and 'cut off losses at once.'

Two examples of robust systems are a moving-average cross-over system and a price-range breakout system. Both systems are well known, and are widely traded in some form or another. The trades from these systems typically last more than 20 days. Hence I classify them as inter­mediate-term systems. They are trend-following in nature, in that they make money in trending markets and lose money in nontrending markets. The typical system has a winning record of 35 to 45 percent, with an average trade of more than $200. I will discuss these systems in detail later.

The key feature to note is that, when systematically implemented over a 'long' time and over many markets, robust systems tend to be, on the whole, profitable. If executed correctly, they guarantee entry in the direction of the intermediate trend, cut off losses quickly, and let profits run. Countless variations of these systems exist, and trend-following sys­tems seem to account for a large percentage of professionally managed accounts.

Robust systems do not make many assumptions about market be­havior, have relatively few variables or parameters, and do not change their parameters in response to market action. There is no sharp drop in performance due to small changes in the values of system variables. Such systems are worthy of consideration in most portfolios, and are reason­ably reliable. In addition, they are easy to implement.

How Do You Implement a Trading System?

Begin with a trading system you trust. After sufficient testing, you can determine the risk control strategy necessary for that system. The risk control strategy specifies the number of contracts per signal and the in­itial dollar amount of the risk per contract. The risk control strategy may also specify how the initial stop changes after prices move favorably for many days.

The system must clarify portfolio issues such as the number and type of markets suitable for this account. The trading system must also specify when and how to put on initial positions in markets in which it has signaled a trade before commencement of trading for a particular account.

Developing and Implementing Trading Systems

A trade plan is at the heart of system implementation. The trade plan specifies entry, exit, and risk control rules along with the statistical edge. You should record a diary of your feelings and the quality of your implementation, plus any deviations from the plan and the reasons for those deviations. You should monitor position risk and the status of all exit rules.

Last, take the long view: Imagine you are going to implement 100 trades with this plan, not just one. Thus, you can ignore the perform­ance of any one trade, whether profitable or not, and focus on executing the trade plan. These and other implementation issues are discussed in detail in chapter 9.

Who Wins? Who Loses?

Tewles, Harlow, and Stone (1974) report a study by Blair Stewart of the complete trading accounts of 8,922 customers in the 1930s. That may seem like a long time ago, but the human psychology of fear, hope, and greed has changed little in the last 60 or so years. The results of the study are worth considering seriously.

Stewart reported three mistakes made by these customers. (1) Speculators showed a clear tendency to cut profits short, while let­ting their losses run. (2) Speculators were more likely to be long than short, even though prices generally declined during the nine years of the study. (3) Longs bought on weakness and shorts sold on strength, indi­cating they were price-level rather than price-movement traders.

I should contrast this experience with the TOPS COLA philoso­phy discussed earlier. By taking profits slowly and cutting off losers at once, you will avoid the first mistake reported by Stewart. Second, by being a trend follower, you will avoid the next two mistakes. If you fol­low trends, you will be long or short per the intermediate trend, and avoid any tendency to be generally long. Third, if you follow trends, you will follow price movement, rather than being a price-level trader.

You will win in the trading business if you have a specific trade plan that contains all the necessary details. You should focus much of your ef­fort and energy on implementing the trade plan as accurately and con­sistently as possible. Thus, you must go beyond technical analysis, deep into trade management and organized trading, to win.

Beyond Technical Analysis 9

Beyond Technical Analysis

The usual advice for technical traders is a collection of rules with many exceptions and exceptions to the exceptions. The trading rules are diffi­cult to test and the observations are hard to quantify. I want you to go beyond technical analysis by converting an art form into a concrete trad­ing system, and then focusing on implementing the system to the best of your ability. Trading is analysis in action. Thus, this book is an attempt to bridge the gap between the development and the implementation of a trading system.


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