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When you adopt a trading system that gives you entries and exits, your
profit on any individual trade is either positive or negative or zero. The
collection of these positive and negative and null results forms a
distribution. If the mean of this distribution is positive, the system
will on average gain you a profit; if it is negative, the system will on
average lose.
A distribution with a positive mean represents what is called a superfair
bet; a distribution with a negative mean represents a subfair bet. If you
imagine the histogram of the distribution to be made of rigid wooden blocks
with a fulcrum at the zero point on the horizontal axis, a superfair
distribution will topple to the right and a subfair distribution will
topple to the left.
The only way to win consistently in any gambling game is to make superfair
bets consistently. A system's theoretical distribution and its statistics
are not available but can only be estimated using back data. Any
conclusions derived from back data are subject to sampling error and this
error must be sufficiently small as not to invalidate the conclusions.
The standard way to examine the profitability of a system is to back test
it. This is what TradeStation does. However, the right way to look at any
trading situation (and any investment situation) is to consider it as a
gamble, with positive or negative payoffs derived from the distribution of
payoffs, and to examine the distribution of those payoffs.
Price movement is a stochastic process, and the task of the trader is to
find conditions that cause him or her to jump on and off that process so
that s/he on average buys low and sells high, in whatever order, yielding a
superfair profit distribution. A setup is a market condition that causes
the trader to jump onto that process and an exit strategy, well-defined or
improvised, is what causes the trader to jump off.
Call the combination setup/exit strategy a "system". An intuitive or
discretionary trader can also be considered to have a system, or a number
of systems, each with a profit distribution, although the entries and exits
are not hard coded or as easily testable.
A system is a gambling strategy and has a distribution of profit. Each
execution of a trade triggered by the system is a gamble. It is a good
gamble or a bad gamble according to whether the mean profit is positive or
negative. If the system is superfair, it will yield regular profits as
long as proper money management is used.
The standard deviation of the distribution is also important; among other
things, it tells you how consistent the system is. Additionally, the tails
of the distribution contain information that is valuable to the trader of
the system. The right hand tail describes the structure of the profits
and the left hand tail describes the structure of the losses.
The trader improves the performance of the system by reducing the leverage
(weight times distance from the center) of the left hand tail and
increasing the leverage of the right hand tail. "Let your profits run" is
advice that is supposed to increase the leverage of the right hand tail,
and stop losses are meant to reduce the leverage of the left hand
tail. More analytically, the tails are rebalanced by understanding the
conditions that accompany them. Such conditions are sometimes complex and
can only be unearthed with great difficulty.
A successful trader is one who has identified, either analytically or
intuitively, market conditions that generate superfair distributions and
who regularly makes superfair bets. A trader improves only by adjusting
the tails as described.
Anyone familiar with stochastic processes and gambling theory will
recognize immediately that this is the right way to look at trading
systems. I have developed a software package for my own use that derives
these distributions, displays them and their important pieces, uses pattern
recognition techniques and genetic algorithm technology to improve them by
incorporating interesting new measurements, conditions, indicators, and
information. The package has a lot of value for the informed trader.
This is not a trading system, but rather a platform containing toolboxes,
analysis techniques and algorithms that allow the user to analyze trading
systems correctly and to improve them. It is the right approach from a
statistical and logical point of view, but no available software analyzes
systems this way, which is why I built it. It is not a TradeStation add-on
but a stand-alone application, although it will accept input from
TradeStation or from any other trading program that can export ASCII files.
This program has the potential to become a standard tool for serious
traders. I would be interested in seeing the program marketed. I am a
statistician and a trader and not interested in marketing, but if anyone
out there has such an interest and also the capability, please contact
me. Please, no individual inquiries -- the development costs have been
sizable.
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