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A few weeks ago I asked what criteria could be applied to a mechanical
trading system such as Odd-Ball. I didn't get much of a response. I wrote
the following for myself to answer the question - what criteria could be
applied in defining what a good system is? I thought that it might be of
interest to someone else.
I would like to know what the list thinks? Any comments?
John
p.s., I live in Russia so my replies might take some time.
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When designing or considering using a trading systems there are several
important considerations that one must answer. The summaries of these
questions are:
1. How much pain can one endure before puking?
a. How long can one hold a losing position?
b. What percentage of equity loss can one endure?
c. Can a trade go from profits to a loss then back to profit?
2. How many trades per; hour, day, week? How much patience does the trader
have to wait for a valid entry signal?
3. How many consecutive losing trades can be endured in:
a. The trading system?
b. In a day?
c. In a week?
4. How long can a drawdown last?
5. Can a position be held over:
a. Overnight?
b. Over the weekend?
6. Are trades;
a. Multiple trades in the same direction?
b. Multiple exits?
c. One entry and one exit (multiple lot OK)?
7. How much Capital does one have?
8. Will proper money management be followed?
9. What percentage of trading capital can be lost:
a. Before becoming overly anxious?
b. Before no longer accepting the trading system signals?
How much pain can one endure before puking?
Perhaps of all the questions this one is the third most important, as
everything revolves around it. Some traders placing a trade will
immediately become very nervous that either they are about to lose their
money, or might wind up giving back some of the profits. Other traders are
not bothered as the market gyrates around creating profits and losses. And
yet other traders will exit a trade as soon as it starts to lose money, or
if it's not immediately profitable. Yet other traders will allow the trade
to lose money for a certain predefined amount of time before becoming
nervous. Every system has the potential to create tremendous stress in the
trader. Before it is possible to accurately evaluate the performance of a
trading system - the trader must first define how much "heat" they can take.
How many trades per; hour, day, week? How much patience does the trader
have to wait for a valid entry signal?
This is totally dependent upon the psychological make up of the individual
trader. Some traders want to only make 1 good trade a day. Others want to
make 1 good trade every 30 minutes. Some traders are unable to sit all day
in front of the trading screen waiting for one signal every other day.
Other traders feel very pressured if they receive 1 trading signal every 60
minutes. This is a subjective question and is only limited by the trader's
psychological reasons and the ease of executing the trades. A on floor
trader is able to execute mush more easily than off floor trader.
How many consecutive losing trades can be endured in; the system, in a day,
in a week?
Every trading system by using historical back testing will indicate the
maximum number of losing trades before a winning trade occurs. It is also
possible to determine the average number of losing trades encountered in a
'typical' trading day. Some traders will unswervingly take every entry
signal that trading system generates regardless of how many consecutive
losing trades are encountered. Other traders after encountering 5
consecutive losing traders will stop trading for the day, and yet others
will become nervous after 2 losing trades.
How long can drawdowns last?
Many of the more professional traders will be more concerned about the
length and depth of a drawdown. A drawdown is the amount of trading equity
that is lost because of consecutive or semi-consecutive losing trading
signals. The length of this drawdown is measured from when the losing
trades start, and ends when the trading equity is equal to or greater than
the equity value before the drawdown.
In a trading system we can define this in the number of trades, or in some
unit of time (hours, days, weeks, months. etc.) Every trader will have
different tolerance levels.
Can a position be held; a few minutes, overnight, and/or over the weekend.
This again is totally dependent upon the amount of pain or heat the trader
can endure. It is also related to a subsequent question regarding
capitalization. In general some systems are able to capitalize upon opening
gaps, and could be very profitable. However if the trade is exited on
close, then re-established upon the open the next day very often the system
performs several orders of magnitude more inferior. Some systems have all
trades exited on or before the close.
Are positions slowly built (multiple trades in the same direction) or is
there one entry? Likewise with the exits, is there one exit or are
positions gradually exited? Or are there only one entry and one exit? This
depends upon the underlying model the trading logic uses. One model
believes that looking for a trend that allows a position to be
incrementally increased can generate more profits. Another model believes
that placing one trade can generate more profits. The exit strategy can
dictate either a gradual unloading of the position or one exit.
This also has a strong correlation to the amount of money that the trader
is willing risk, and the amount of time one wants to be in a trade.
Generally the shorter the length of time and the less the amount of money
willing to be risked - the less likely a trader will want to gradually
build a position.
How much Capital does one have?
This is the second most important question. If one has little capital then
in all likelihood this capital is proportionately more important to the
trader than the same amount of money to a well-capitalized trader.
Consequently the amount that can be lost, the length of time to stay with a
trade, how long a trader can endure a drawdown, and the answer to many of
the subsequent questions all hinge upon this. Perhaps the related question
is; how important is this capital to maintaining the traders lifestyle? If
it is the rent money then besides the fact the trader should not be
trading, the trader will be looking for a system with low drawdown's, and
low consecutive losing trades.
What percentage of trading capital can be lost before becoming overly
anxious, and no longer accepting the trading system signals?
The answer to this question is directly related to the how important the
trading capital is to the individual. For many of the large banks, hedge
funds, and brokerage houses it is grounds for immediate dismissal if a
trader is caught trading their own money. The reason is obvious, while the
traders' income is based upon his performance; he is trading someone else's
money. Consequently he is psychologically able to lose the firms money, it
is not the same as using money that should be going into his Childs college
fund. Consequently the traders' performance is usually better. A trader
using funds that he honestly doesn't care about is psychologically much
better off than a trader using 'important' monies.
Will proper money management be followed?
This last question is the most singularly important question a trader must
answer before designing or evaluating a trading system. This is because the
trader no matter how experienced in trading or programming is in the end
playing in a battleground that is totally dominated by the "law of
probabilities". In order for the trading logic to work it must tip the odds
ever so slightly in its favor. If proper money management is followed it
means that that when the inevitable drawdown begins it can be traded out
of. If proper money management is not going to be followed then it means
that when the inevitable drawdown begins the trader must realize that the
game has changed and stop trading using the existing trading system and
create another system.
The problem with this approach is that in most case the trader will not
realize that he is experiencing a significant drawdown until most if not
all of the profits are lost. In addition the "new" trading system might not
be better than the old system.
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