Developing a Trading System/Strategy

Q. How do you get ideas to develop your system/strategy?

I am not asking for ideas, but merely for 'ideas how to get an idea'. How did you came up with your system. For example: did you read a lot of books, eliminated a lot of bad ideas before you came up with something viable, or did you dream about it?

A: Erm...the best trading ideas generally involve recognising particular types of recurring patterns in the underlying data and which tend to be predictable in that they are closely correlated with particular extraneous, or sometimes endogenous events.

If you can find buy/sell signals with reasonably reliable reward to risk ratios of 3:1 or higher which are consistently successful over many months, you may be on to something. However, be warned that very often apparently reliable patterns fizzle out all too soon when it turns out that there has been a fundamental change affecting some underlying variable. A good example of the latter was the effect on the FTSE constituents of changes in asset allocation, where pension funds switched from shares into gilts a few years back.

Check out what are known to be as 'technical factors', as an understanding of some of these can often boost returns in one-way-bet fashion for short periods of time. A good example would be the 'wall of money' situations where it is known that extra money is coming into markets from somewhere, and which will be greeted by rising ask prices from market makers. Once upon a time equity markets showed patterns involving rises around the end/beginning of the month, followed by odd spells of profit-taking later in the new month.

Read one or two books on trading systems, to get ideas on information handling, and read how chaos theory has helped with interpretation of some of the most intractable data in investment fields. And an appreciation of the effects of high volatility is of paramount importance in today's markets as well - you will also learn a lot from your own trading mistakes... In spite of volatility the markets will still trend around 40% of the time and when they do often break out in to big trends.

As an aside there was a good psychology experiment where they gave bookies 5 bits of information about horses (previous wins, handicap weight, jockey experience etc) and asked them 2 questions 1) which horse would win and 2) how confident they were their chosen horse would win. They then repeated the experiment but gave the bookies 20 bits of information and then asked them the same two questions.

When they compared the results they found that the bookies had the same predictive power of which horse would win when using either 5 or 20 bits of information but when they had 20 bits of information they were 10 times more confident they would pick the winning horse than if they only had 5.

The moral is, whatever system you decide a simple system is as good as a complex one. Personally I think a good money management system and sticking to pre-defined stop losses is the best way to keep out of trouble.

To conclude we never know in advance when the losing periods or the winning periods will be (if we did trading would be exceptionally easy and everyone would do it as we would only trade the winning periods and stop trading through the losing periods) which is why we just follow our trading system. The successful ones in trading are those who accept there will be losses as well as gains, and who look at the overall picture. You have to be patient and accept the losses, and wait for the really big winners, because when we win, we win big.

Note: For every system/method there are going to be winning periods, and losing periods, and good examples and bad examples. To find out whether a system works or not you've got to execute sufficient trades from it to find out whether its statically sound or not. Imo one of the most important factors to consider is that if a trade goes wrong you need to know where you're going to get out (this is much more important than the entry).

There's a phrase called 'picking nickles in front of a steamroller'. If you have positive expectancy, you can expect to make a profit over the average of your trades. Negative is the opposite - you will end up with a loss. Tight risk management is one of the keys to this.
Positive Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

Q. Should you buy or use a trading system?

A: System trading (sometimes referred to as a mechanical trading system) is the use of a clearly stated and exact set of criteria for trading a financial asset which should include entry and exit points. These entry and exit points can depend on various technical setups or indicators as well as chart patterns, trading volume, open interest and sometimes even fundamentals. Lots of trading systems are available for purchase over-the-counter while many others have been developed by stock market traders for their own personal use. Most of the trading systems available today are run on computers due to their complexity since these systems can have many different variable parameters; other system are however very simple and can be based on a simple moving average crossover method that triggers buy and sell signals at each moving average crossover.

Advantages of using a trading system:

-> A key advantage is that they take the human emotions out of trading.
-> Trading systems can also be backtested by feeding the programme many years of past historical data. This will allow modifications to a trading system to be made so as to improve the system further based on historical prices (these are the famous 'hypothetical' trading results).

Disadvantages of using a trading system:

-> Drawdowns. A repeat number of losers can be devastating to a system trader with a small trading account (recall if you start with $100,000 and lose 50% of this you end up with $50,000 but then you need to make 100% to get back to breakeven).
-> Hype. Hypothetical back-testing is just theory and system marketers conveniently forget to tell you about maximum potential drawdowns.
-> The fact that systems remove emotions from the trading equation can be a disadvantage in itself as it removes the value of 'trader intuition' and 'experience' which can be very valuable in certain circumstances (the human brain is much more flexible than any computer programme can be).

So, should you use a trading system? The response is different for different people but you shouldn't spend thousands of pounds on buying a trading system thinking that this is the way to Major Moolah. Instead (at least at first), it might be a better idea to buy some books on the subject of trading. You should definitely understand some of the basic workings and trading tools before considering a trading system.

Q. Why is that most commercial trading systems don't work?

A: My theory as to why commercial trading systems don't work is that the people who develop and sell the systems are more interested in making money selling the trading systems, rather than helping their clients make money in the long term. Its my personal opinion that if a individual is serious about trading the financial markets, they'll take the time to research and develop their own trading strategy. It will pay off better then giving someone else money for a product that may or may not be reliable, or may or may not know what they are talking about. I've encountered a fair amount of people professing to be 'Gurus' in my research that claim to know what they're talking about but have no idea what they really are saying.

 ...KISS Trading Strategies

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