What Can We Expect from a Trading System?

by D. R. Barton, Jr.

I really enjoy small sayings that capture the essence of issues.  During one of our trading courses, we were discussing various trading systems and execution platforms.  One of the attendees summed up the essence of where the responsibility for performance lies by saying, “It’s the dancer, not the floor”.  And so it is with trading systems.  They are important tools, but they are not the only part of the equation that goes into making a successful trader.

Let’s look at some of the most common issues around system trading and see if we can lend some clarity using the good old “pro and con” format:

1. If I can find a trading system that works, then I can be a successful trader.

Pro:  Every trader needs a strategy or system to form a framework for their trading.  Without a repeatable way to identify and execute trades, one can never be a consistent performer.  A good system or strategy also gives a trader the confidence to act decisively. It’s difficult to underestimate the importance of having full confidence in your trading, especially after going through a drawdown.  In addition, a good system, when executed with discipline, can produce good returns, especially when used in the right market conditions.

Con:  There have been studies done where groups of people have been given proven trading systems and still not made money with them.  This is because your trading system or strategy is only one part of the package that makes a successful trader.  While a trading system can support your trading discipline (as mentioned above), it cannot take the place of developing your trading psychology.  And there are other parts of your “tradecraft” that you must develop – business and trading plans, execution skills, adapting to changing markets, etc. 

Summary:  Your trading system (or systems) is an important foundation of your trading.  But it is not the only important element.  Spend serious time on strategy and system development.  It is one of your primary tasks.  But it is not the only task!  There are many folks out there who are obsessed with system development and never seem to find time to trade (the Internet bulletin boards are full of them!).  In addition to your strategy development, spend significant time on the other key areas of trading including your psychology and your tradecraft.

2. The best systems should work in trending and sideways markets.

Pro:  Multiple market conditions are a fact of life.  Studies show that markets actually trend as little as 20 – 30 percent of the time.  So even the trendiest markets have significant amounts of time when they are going sideways.  A system that can work in both trending and sideways markets is truly valuable.  Most systems that endeavor to tackle both types of market conditions usually do so by first identifying whether or not the market is in a trend and then picking one trading algorithm or another.  Others address the problem by trading less in one type of market or the other.

Con:  Products that try to “be all things to all people” usually do a mediocre job for everyone.  Consumer Reports magazine once did a study of laundry detergents and fabric softeners and also of products that combined the two.  They found some excellent detergents, some excellent fabric softeners and some combinations that were acceptable at both tasks but excelled at neither.  Designing a “one size fits all” system for trading is a difficult proposition and is likely to end up giving results, which much like combination laundry products, fail to excel in any market condition.

Summary:  Understanding the current market conditions is a key task for any trading strategy.  As traders, we need to know what types of market best fit each of our systems.  Trying to design a trading system that navigates all market conditions is a daunting task that has challenged even the best system designers.  A more useful approach, especially for those who are just starting out, is to design different systems that work really well in one type of market condition and then determine a way to switch between systems or scale into and out of the different systems.

3. Systems designed to produce a high winning percentage are best.

Pro:  Systems that produce higher winning percentages are certainly easier to trade from a psychological perspective.  Losing streaks are shorter, and winning streaks are longer.  Systems that get fewer, but bigger winners can seem like “death by a thousand cuts” during periods of extended losing streaks.  And because long losing streaks are less likely, high percentage trading systems can typically use more aggressive position sizing.

Con:  Almost all systems with high winning percentages have low reward-to-risk ratios.  So even during times of extended winning streaks, they may be adding to your equity curve slowly.  Systems with big reward-to-risk ratios tend to catch the really big trends.  These are the moves that provide truly outsized returns that can change a good year into an incredible year.

Summary:  First of all, there really is no “best” in the world of trading.  With that said, ther most likely is one “best” for your individual situation.  There are only two meaningful parameters for deciding whether you should design for a high percentage of winners or a high reward-to-risk ratio.    The first is your own personality and trading psychology.  The second is the combined expectancy and frequency-of-trade for each system.  If you compare two systems on the basis of expected profit per month, quarter, or year, it can be quite an eye-opener.  But great theoretical results really won’t matter if you can’t trade that type of system well.  Results generated by a long-term system that has significant drawdowns won’t work for you if you’re a very impatient person who likes lots of positive reinforcement.  The system has to fit you if you are going to trade it well.

D. R. Barton, Jr. is a lead instructor for Van Tharp Institute (IITM) courses. He has presented at How to Develop A Winning Trading System That Fits You, Day Trading Techniques, Swing Trading Techniques, Make Money Work for You and many more. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has created extensive and innovative new training products and taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

Tharp's Thoughts: 190_Oct_13_2004

Exits - Are Your Money Management Stops Too Large or Too Small?
by Chuck LeBeau and Terence Tan

It seems that Money Management stops are either too close and subject to frequent whipsaws or too far away and expose our capital to large losses. From the results of our testing, we have concluded that most systems would benefit from the inclusion of relatively large money management stops.

At first thought it would seem that the closer the stops and the smaller the losses, the lower the expected drawdown. However, this seemingly logical assumption does not hold up in testing. In almost all cases the wider stops result in a higher winning percentage and a lower drawdown. Smaller stops appear to be psychologically attractive, but may actually deteriorate system performance because they are susceptible to frequent "whipsaws" caused by random and insignificant price movements. On the other hand, large stops may also be psychologically attractive because they are activated less frequently, and systems with large stops generally tend to have a higher percentage of winning trades. However, the down side is that large stops force the trader to occasionally suffer rather large losses which, although infrequent, can be psychologically difficult to accept as well. Is there a compromise solution to this problem?

We believe there is. An interesting phenomenon we have observed from our research is that it is often possible to tighten the money management stop a short period after the initial trade entry. It has been our preference to allow the trade some latitude to work out in the beginning and this is best accomplished with a relatively large money management stop during the first few days of the trade. However, after a specific number of days the money management stop can often be reduced to a much smaller amount. For instance, if we have a $5,000 stop upon entering a trade on the S&P 500 futures market, and this is an uncomfortably large loss to take, it may be possible to leave the $5,000 stop in place only for the first few days, and then tighten the stop to $2,500 for the remainder of the trade. The chances of being stopped out late in the trade with a $5,000 loss have been reduced, although it is always possible that a large adverse price movement in the first few days could still stop us out with the maximum loss. The exact stop amounts and the time of implementation would have to be determined by computer and statistical analysis of the system's characteristics. In some trend-following systems, we have found that we can benefit substantially by implementing a larger stop in the beginning of a trade, and then reducing the original stop by 50% or more once the trade is underway.

This technique of tightening stops after a few days in the trade has a sound basis: we know that the predictiveness of a trade entry indicator declines as the trade moves out into the future. In most cases an entry indicator has a better chance of predicting the price movement in the next 2 days than in the next 2 weeks. Starting off a trade with a large money management stop allows the trade sufficient room to work in the right direction, since it corresponds to a period of high confidence in the entry indication. As the trade moves out into the future, the confidence of the entry indication declines, so we tighten up the stop to reflect decreasing confidence in the trade.

Other possibilities for dealing with the problem of large stops also exist. Stops such as breakeven stops or profit protection stops that over-ride the money management stop can easily be implemented in later stages of the trade. Once these stops are activated, the possibility of taking the large original stop loss is substantially reduced or eliminated. These and other techniques will be fully discussed in subsequent chapters.

Conclusion

Proper understanding and implementation of the money management stop is vital to a trader's survival. The stop effectively limits the maximum loss that may be sustained in a trade, which in turn contributes to the all-important goal of preservation of capital. Trading without a money management stop is to allow for a high chance of catastrophic loss in your account.

The importance of the Money Management stop is aptly summed up by Jack Schwager with this statement from his book, The New Market Wizards: "If you can't take a small loss, sooner or later you will take the mother of all losses."

About the Author: Chuck LeBeau  is the co-author of Computer Analysis of the Futures Market, and the former co-editor of Technical Traders Bulletin. Chuck is often a featured speaker at IITM's  How To Develop A Winning Trading System Workshop.  Chuck has 27 years experience in the markets and is widely known for his specialized knowledge of technical analysis. He also develops trading systems and currently runs a website devoted to trading topics.

Tharp's Thoughts: 188_Sept_29_2004

Trading Tip

System Performance

Part One

by  D.R. Barton, Jr.

“When I was losing, they called me nuts. When I was winning they called me eccentric."

-- Al McGuire, college basketball coach

“That system I bought stinks!  The first three trades I made with it were all losers.  I wasted a thousand bucks on that piece of junk!  I’ll never trade that thing again.”

I have heard such tales over and over, whether the person is talking about a canned system they bought, newsletter recommendations or a system they developed themselves (although folks are usually less critical of things they develop themselves – more on that later).

For our system development conference call last week, we took written questions over the Internet.  Unfortunately, we didn’t have time to cover all of them.  One set of questions was along these lines:  How do I choose between systems?  How do I know if a system is broken?  So to answer this line of questions, I’d like to do a series of articles on system performance.  Here are some topics we’ll cover:

·        What are the key criteria to use when judging a system’s performance?

·        How can I choose between two competing systems?

·        When does a string of losses get too long to call the system into question?

·        What are acceptable drawdown levels?

·        Should I look for a system with a high winning percentage or high R multiples?

·        Should I buy a system or spend the time to develop my own?

This will be a great lead-in to our upcoming Systems workshop the second weekend of November.  I hope you can join Chuck LeBeau and me!

To respond to those folks who throw systems out after three losses: Unless your system wins 95 percent of the time, three losses in a row is rarely something to worry about.

Tharp's Thoughts: 191_oct_20_2004

System Performance, Part Two
by  D.R. Barton, Jr.

This week we’ll continue with our series on trading system performance by looking into the issue of system choice.  How does one choose between two competing systems?

There are two significant areas to consider when choosing between trading systems.  The first is matching the system’s trading philosophy to your trading beliefs. The second area is the performance statistics of the systems.  Most people spend 98 percent of their time crunching the numbers.  The other two percent of system development time is spent preparing snacks. No one spends any time worrying about whether they will actually be able to trade the system they pick.  So let’s spend a balanced amount of time looking at the psychology of trading the system (this weeks article) and digging through the performance numbers that will compare two systems (next week’s article).

“Yeah, I can trade that.”   I’ve heard it hundreds of times, “Just show me something that works, and I’ll trade it.”  We all wish it was that easy.  Trading takes a combination of skill and talents.  And one of the most important skills is knowing what type of systems and strategies you can trade well, day-in and day-out.  So the first thing a trader must determine when choosing between systems, is which one fits his or her trading style better.  Here are some questions that should help you determine which system is more aligned with your trading beliefs:

• What time frame does this system use (long term position trading?  Intra-day trading? Something in between?  Is this a time frame that I am very comfortable with?

• Does this system trade predominantly with the trend or take mostly counter-trend trades?

• How frequently does the system trade.  Is that too much or too little for your activity level?

•  How much of your investment capital will each of the systems require?  Is this an amount you are comfortable with?

Be very careful if you are tempted to fall into the “I can trade it if it works” trap.  Because, if the system that seems to work well on paper loses too many in a row or has one or two losses that are too big for your tastes, then you will be more than likely to toss out a good system.  Understand your market beliefs and your comfort zones and you’ll be well on your way to matching them to a useful trading strategy.  Next week we’ll look at how which performance measures should draw most of your attention.

Tharp's Thoughts: 192_oct_27_2004

System Performance, Part III

 In our series on system performance, we’ll look at some of the quantitative measures you can use to compare two systems that you may be considering.  In Part II  we looked at matching your market beliefs with those of your system or strategy.  I can’t overemphasize the importance of this aspect of your system selection! Let’s look at some of the basic quantitative measures that you need to look at when comparing systems.  There are enough of these important measures to cover this week and next week.

·        Winning percentage vs. High R-Multiple returns.  We’ve discussed this metric before and in most instances, these are inversely proportional items (meaning that as one increases, the other decreases).  The holy grail would be a system with high average R-multiples that has a very high winning percentage.  While I’ve seen a few systems that do both, they invariably achieve this unusual combination by finding very infrequently occurring market conditions.  These types of systems are the ones that have set-ups that come along only a few times per quarter or year.  But be sure you know your ability to last through drawdowns and losing streaks.  If you pick a system that generates big R-multiples, but has a winning percentage below 50, you have to have a patient demeanor.  Remember to match your system with your personality and beliefs!

·        Average profit per trade.  This is one of my personal favorite measures.  It encompasses a lot of other system characteristics including expectancy, average loss size and average win size.  When combined with frequency of trade, average profit per trade can tell you more about your system than most other individual measures.  While this is one of my favorites, you really need to combine it with an understanding of the next item to make sure that you don’t get fooled by one or two unusual results.

·        Outsized winners.  As you review trading results, especially back-tested results, keep a close eye out for really huge returns that happen only once or twice in a data run.  I have seen some long term trend following systems that put up great results because they caught a huge move in one stock or commodity.  If you caught Qualcomm for a 200 point move in 1999, you could have a bunch of other average trades and still do well.  What is wrong with having a big trade or two that reflect a “letting your winners run” mentality?  The main thing is frequency.  If these outsized winners are happening once every two or three years, it will be tough to trade your system while waiting for that next big score.  Another potential problem is that the outsized gains were made when one-time events came along, like a system that was short for 9/11/2001 or when the Hunt Brothers tried to corner the silver market.  The bottom line is that knowing the average returns is not enough, you have to know the individual trades that were used to generate those numbers.

Next issue we’ll look at some of the aggregate measures that are useful in comparing systems.

Tharp's Thoughts: 194_nov_17_2004

System Performance, Part IV

We’ve been reviewing system performance measures and last week we looked at some individual measures that are quite useful.  Today we’ll look at several ways that combine or aggregate data to provide a broader measure of system performance.

·        System expectancy multiplied by frequency.  Van has been a great proponent of measuring a system’s expected value and he has written about it extensively.  Because of the bias humans have for being right, many (if not most) people judge systems based on the percent of time the system wins without giving the ratio of the average winner versus the loser equal consideration.  There are many good places to read up on expectancy including all three of Van’s books, but conceptually it measures the average expected profitability of a given system in terms of dollars won per dollar risked.  To make a performance metric that is truly applicable across all instruments and timeframes, you can multiply expectancy times the frequency of the trade or investment.  This will give you a “dollars per month, year, etc.” figure that you can use to compare any system.  With this combination of  expectancy and frequency, you can answer the question “Does that day trading system for S&P e-minis, that long term stock trading system, or that real estate strategy that flips properties a few times a year look better?”

·        Annual percent increase divided by worse case draw down.  What the first measure (expectancy times frequency) won’t tell you is how much pain (or draw down) you will have to suffer to generate those average gains.  A ratio I like to use is the average annual percentage gain divided by the maximum draw down.  This gives us a ratio of  how much we make per year divided by how much we would be down at any time during the year.  Or in simple terms:  How much will I have to risk losing in order to generate my average returns?  Any ratio of that is less than 2:1 is suspect (do you really want to risk a 50 percent draw down to make a 50% gain?).

·        Industry standard performance measures.  Let’s close by looking at two composite numbers that many money managers use to measure their performance:

1.      Sharpe Ratio:  (system rate of return – risk f ree rate of return) / standard deviation of system returns.

o       The Sharp Ratio measures risk to reward by giving the returns of the system as a ratio to its standard deviation. If the system has very constant returns, it will have a high Sharpe Ratio.  A system with returns that vary greatly period-to-period will have a lower Sharpe Ratio.

2.      Sortino Ratio: One problem with the Sharpe Ratio is that it penalizes a system for a big up month or “good volatility”.  The Sortino Ratio attempts to overcome this issue by dividing the same risk adjusted rate of return used in the Sharpe Ratio by only the negative deviation or “bad volatility” (the downside semi-variance).

The bottom line for measuring system performance is that you have to understand what criteria are important for your situation.  And don’t just base your decision on one measure of performance.  With all of the tools at our disposal for measuring performance, it is prudent to put them into use as you choose, design and use a system.

Tharp's Thoughts: 195_nov_24_2004

D. R. Barton, Jr. is a lead instructor for Van Tharp Institute (IITM) courses. He has presented at How to Develop A Winning Trading System That Fits You, Day Trading Techniques, Swing Trading Techniques, Make Money Work for You and many more. 

He is the Chief Operating Officer and Risk Manager for the Directional Research and Trading hedge fund group. D. R. has been actively involved in trading, researching and teaching in the markets since 1986.  D. R. has created extensive and innovative new training products and taught extensively in many investment areas including intra-day trading, swing trading, and cutting edge risk management techniques. 

Don’t Take Just Any Ol’ Entry

Trading Tip

by  D. R. Barton, Jr.

“A single advantage is worth a thousand sorceries.”
                                                --Turkish proverb

As traders and investors, we’re always looking for an edge in the markets.  Today we’re going to discuss finding edges in our entries.

But before we talk about entry edges, let me be clear that I believe that entries are much less important than money management, stops and exits when it comes to system design.

With that said, there are still some useful ways to approach the design and execution of entries that can give you some additional advantages in the way you initiate your trades.  Let’s look at a few questions and concepts you can use to make more effective entries.

·        Is your entry technique consistent with your strategy’s market concept?  When I speak of your system’s “market concept,” I’m talking about the beliefs upon which your strategy is built.  For example, if you have a system that identifies a channel and then buys the bottoms and sells the tops, you need some sort of counter-trend entry that will allow you to sell near the channel tops and buy near the channel bottom.

Some trend following systems count on getting a good entry on the long side by buying a pullback.  Since these are longer-term systems looking to capture longer-term trends, this can be an excellent strategy.

On the other hand, if your strategy is a breakout / breakdown system, then you are best served quickly following the price move after confirmation.  Waiting for a pullback will most likely lead to either of two unwanted results:  the price will never pull back and you miss the entry on a good trade, or the price pulls back and just keeps moving against the breakout for a loss  (a routine occurrence in breakout trading).

·        Do you have to get in now?  This is a great question for folks who follow long-term newsletter recommendations and those who take trades based on fundamental data.  For those trading on a shorter time frame or following a technical system, in most cases, you should take entries as they occur.

But back to those following long-term newsletter recommendations:  Jumping blindly in at the exact minute you hear or read about the recommendation is probably not the best entry technique.  If a popular newsletter with a big subscriber base makes a recommendation, LOTS of folks are going to be jumping in.  And unless the stock is very liquid, it will be a bit like someone yelling, “Fire!” in crowded theater – everyone wants to get through the same door at the same time.

Instead of fighting a newsletter “cattle call”, you might try waiting for the price to pull back a bit after the initial run-up.  A 50 percent retracement  of the move caused by the recommendation is a good rule-of-thumb to use.

·        Have you mastered the art of “stalking”?  One of Van’s famous Ten Tasks of Trading is stalking your trade.  Just like a cat stalks its prey looking for the best possible moment to pounce, so a trader can stalk an entry to get the best price for entry.  For a trader or investor entering a long-term trade based on fundamental analysis, stalking may include adding some technical analysis to help with the timing of the entry.  In almost all cases for long-term trading, waiting for the price to enter an up-trend is a good idea.

Shorter-term traders may use the Level II screen to help them stalk a trade.  The Level II tool helps to give traders a rough idea of the very short-term supply / demand balance for a given stock.  When used with an understanding of its strengths and weaknesses, the Level II screen can be a very useful stalking tool to help give traders an edge in getting the best entry price for their trade.

Tharp's Thoughts: 212_mar_23_2005

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