Spread Trading Systems - to use or not to use?

The average spread trader is bombarded with touts and ads as to various systems he might buy or use. But why would a trader use a trading system and which one should you choose? - all this and more is discussed in the article which follows -:

Spread Trading Systems

Many beginning spread traders lack a consistent plan--or path of reasoning--by which they make their decisions. They may make trading decisions after reading an article in the newspaper, hearing some news on CNBC, or seeing the weather report. I've known of clients who bought options chiefly because it was the hurricane season.

The trading of some beginning traders is almost random. Some traders choose their trades after receiving an email touting the 'trade of the day' or 'trade of the week' from their brokerage office or advisory firm. Now, some brokers as individuals have excellent recommendations, but not all do. Some futures traders remind us of sports bettors in the movie 'Two for the Money'. Like the clients of certain sports handicapping services, they are very happy after a few consecutive wins. They may well increase the size of their positions. Then, they are caught disastrously unaware as their broker or service makes several losing trading recommendations.

As a result, to survive and prosper, many speculators begin to look for a trading system or systems. In fact, some successful traders are simply those who have found a reliable system. Some simply stumbled into a reliable system. Others look for months or years before they find what they want and need in a system.

Using a system should result in two advantages. The speculator himself or the developer of the system--will have studied or reviewed the previous several dozen or several hundred highly similar set-ups (some system developers review several thousand). The one who has studied these several hundred set-ups knows what now seems to be the likely unfolding of the pattern he sees.

Based on the past behavior of the market, the speculator can make an educated guess about the profitable way to trade, given the current market pattern. And, he can also make the educated guess that, even if this particular trade today doesn't work out, the next five or ten trades taken based on the "system" are likely to result in more profit than loss.

Also, when trading without a system, speculators are likely to make poor decisions based on fear and greed. The market goes against them and they liquidate their position at what is often the high or the low. Some traders take positions for which there is no good reason other than the excitement of being in the market. For some, they enjoy seeing if they can outguess the market in the same way that others enjoy the slots or blackjack in Las Vegas. Their trading usually does not last long.

So there are strong advantages in using a system. The speculator hopes that the system will keep him from making irrational decisions. And, he hopes that the system will have been tested in the same way medical researchers test new drugs and will perform in the future as tested in the past.

It doesn't always work out that way. I've known several who have paid between $2,000 and $10,000 for a system, software or training program and afterwards believed that it was advertised in a misleading way. After buying it, they became convinced it did not do what its sellers had alleged it would do. I have friends who have spent money on futures trading systems only to find they were unworkable. In fact, some say that these persons are members of the $3000 club. The "club" is those who have spent $3000 on a trading system.

By one standard, they are the lucky ones, because they are only out their purchase price, which is usually an amount in the area of a "few" thousand dollars. And at least sometimes, these systems work. What is more painful to hear is of investors who've lost thousands upon thousands upon thousands of dollars after putting real money at risk in trading the signals from a series of different systems or advisory brokers. The first system they tried was one that was supposedly reliable and profitable. In fact, it lost money for them. And then they went from it to a second, and then a third, and then a fourth.

How do we evaluate potential systems? What makese a system 'good' or 'bad'? Is a system likely to work in the future? How would we know? Can we even make a guess about that?

Here are questions we might ask of possible systems, software and advisory brokers:

Is the system or software subject to any independent tracking of its signals? There are several services or websites whose function is or includes tracking the performance of systems, signals and/or advisory brokers. These websites are futurestruth.com, timertrac.com, autumngold.com and thetaresearch.com and several others. Is the system, its signals or the signals of the advisory broker being tracked by an independent source? If not, why not?

If the system or signal series was created more than a few months ago, and if it is any good, it is likely that there is independent auditing of its signals to demonstrate its performance since the time it was created. And this is true even of systems for which no one has yet traded real money.

Once I talked with a trader who had been through two systems and had just moved his money to signals being generated by a "an advisory broker." I asked if this advisory broker had his performance being tracked and audited by the people at autumngold.com. The answer turned out to be no.

Within a few weeks, the results in this fellow account gave us a good clue as to why the advisory broker's performance wasn't being reported at autumngold.com. It was terrible. In the absence of independent auditing of results, the closest proxy would be statements or factual information from the brokerage which holds accounts which are trading the system.

What is the track record of the system or service? This is a good question. A lot of people ask this question without asking the question about independent auditing of performance. In the absence of independent of proof of performance, one should assume that there are liars out there who lie about their own performance or the performance of their trading system. It has happened to me at least three times when I was doing some web research on some system or software that I found reports of CFTC/FSA enforcement actions against the developer. These actions alleged various forms of fraud or other violations of the securities or futures trading laws. And these were software developers or systems developers who were still in business selling their services!

A few years ago I was checking on a system advocated by a certain brokerage. I asked what its return had been over the last year and over the last several years. The broker who was recommending the service told me he didn't know, but if I would track the signals for one month I would be convinced. "Seeing is believing," he said. Maybe seeing one month of signals is enough for some clients, but I prefer to see the results over several years.

I know one fellow who makes market predictions or calls, many of which have been recorded in books or newspapers. He claims to have a track record far better than he actually has. He does this by reporting falsely what he had predicted so that his predictions match what the market later did. You wouldn't spot the fraud unless you check the old newspapers or the webpages which have those old newspaper articles.

Is the 'track record' of hypothetical performance in the past, or was it produced real time? When was the system created and what has been the performance since then? Unfortunately some futures brokers have misled some clients in some instances. Potential clients have told me that their futures broker told them that a certain program was great and had produced returns of 100% a year over the past several years.

In fact, the 100% annual returns were hypothetical returns, not with real money, produced in real time. And why does this matter? The behavior of the market is fully able to change over time. For example, the year 2006 has seen less volatility in the S&P and the currency markets than have previous years. Trading systems which were designed in years of higher volatility, and which were designed to exploit volatility, have "gone bad" recently. The reason isn't fraud on the part of the system developer, but the market itself has changed.

If the trading results were produced real time, will a change in market behavior ruin the results of the system? While this has happened recently with certain volatility-based systems, the same potential exists with many common programs of selling stock index options.

Selling stock index options can regularly provide a monthly increase in one's account, but with the risk of ruin if not handled very carefully. The best example of this is the case of Long-Term Capital Management. They were a giant hedge fund with billions of dollars under management. On their staff was one Nobel Prize winner, who was partly responsible for the creation of the Black-Scholes option pricing model. Long-Term Capital Management had many months of gradual growth. They (and others, for that matter) were short option volatility going into August 1998.

In August 1998, nearly every position held by LTCM was going against them by abnormally large amounts. Their mathematical models had indicated that this event should never occur in the lifetime of the universe. Yet, it was happening before their eyes. Within a few weeks, the Fed organized a consortium of banks to purchase LTCM and gradually close out all their positions.

Other important questions relate to drawdowns incurred as a result of trading the signals of a system. There are many seemingly profitable systems which have had drawdowns of equity of 50% or more. And, many traders wouldn't continue to trade a system after having experienced a drawdown of 30 or 40%, no matter how good it seemed in the past. For some traders, the only tradeable systems are those which have drawdowns of less than 15 or 20% of equity from any given point in time.

Note that a system developer may, inadvertently or intentionally, hide his drawdowns from potential clients. Here is one way it is done. The system developer says, "I've recently done an extensive study of the market and derived several new indicators and a system for trading the market. And, over the last several years, this system would have taken several hundred points from the market in trading S&P futures. Moreover, since my system began to function real-time, it has continued to take substantial profits." Does this sound impressive? If it is true, it is. However, what is missing is this: If a person had been trading using this system in the last six or ten years, how large would have been any and all large drawdowns?

Moreover, suppose one had decided that as one's account increased in size, that one would take progressively larger positions. Many traders do exactly this. If one has increased his position size and simultaneously entered a period of consecutively losing trades, how bad will things get for one's account before starting to win again? There are at least two functioning websites right now which offer stock market signals and which have had at times a seemingly fantastic return. They have a seemingly fantastic return until you also consider the actual or hypothetical drawdowns some of their clients have experienced. And those drawdowns make them more like the sirens of old than a rock on which a trader could rely.

Another useful question to ask is whether or not the input variables of the system (or model) have a rational relationship to the price behavior. Let's consider the following system: If the close of today's S&P is lower than yesterday's close and lower than the close of 3 days ago and of 4 days ago, and if the close of 3 days ago is lower than the close of 4 days ago, buy one S&P the next day market on open and exit on the close.

A Tradestation simulated run indicated in January of 2006, that "system" would have resulted in large profits, hypothetically speaking, over the previous six years. Now, the system works over the past in the S&P, but not in the Russell 2000. Are the results of the system a fluke?

From January 2006 to September 2006, the system would have produced a large loss. Why? Is it simply a statistical fluke over period of years and covering dozens of trades? Did the market change its behavior? Is the loss in 2006 simply a drawdown in a system that will be profitable in the long run? I don't know. I have no idea, in fact.

What I do suspect is that if a system is being built, it has a greater likelihood of 'working' after it is built if the inputs, variables or paramaters of the system have some rational relationship to future price action. Otherwise, the market itself may change. Then, the system might no longer function profitably.

Traders must realize that markets do change over time. The use of systems themselves changes the markets over time. Systems may increase or decrease market volatility and change it in other ways. Also, as any given profitable system becomes known and widely used, market participants may act in ways to take advantage of what they know to be the behavior of those following the system.

Some markets are believed to have a consequent effect on other markets. For example, some believe that the price of crude oil and/or treasury bonds has a lagged effect on the prices of stocks. If this is true, then, systems might be built to exploit this. And, such systems would perhaps continue to work, despite changes in market volatility. Because markets might change and one system begin to fail, one strategy that some would use is to allocate various portions of one's funds to the signals of diverse trading systems.

There are 101 profitable systems on the internet...

There are 101 'profitable' systems on the internet. You don't even need to pay for them. They work very well. Here comes the problem. The markets are in constant change. The characteristics change. Just watch one currency pair or index for 6 months and you'll see what I mean. So these systems that were ultra profitable ('90% win rate!! Look at my statements!!') can become a non-profitable system in the blink of an eye. And you won't know until it is too late. The system stops working and you don't realise it. You get 3 losses in a row. Money management keeps things sane. You tell yourself it's just a drawdown and this period will pass. You get a win. You sigh with relief. You get another 3 losses in a row. A win. 5 losses. A win... it goes on. And then you're down to 50% of your account.

Another scenario: you try some winning system. From the outset you lose money. You ask the author/creator what he's doing. The author is doing exactly what he said and he's profited the entire time you were losing money. Why are things going wrong for you? It's a discretionary system and only experience can teach you how to trade.

So the two aspects that make up a profitable system: the rules and the trader. The rules can become ineffective by a change in the environment (I don't just mean that things become more volatile). The entire system can fail because a different trader has a different mindset. So you need to understand why the rules work and how you think.

It's* hard work. Damned fascinating stuff, though.

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