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Nuances of Systematic Trading

by 

D.R. Barton, Jr.

“Give us the tools and we will finish the job.”

— Winston Churchill

Have you ever known someone who was completely rigid in the way he or she approached a task, especially if the task was fairly sophisticated?  I call these people the “my way or the highway” folks.

These people can only see one way to do something.  When confronted with a twist or new external influence, they seem like the proverbial bull in a china shop charging through the situation.

You’ve seen these folks in other areas:

• The bureaucrat who has always filled the form in one way and can’t do it another way, even when it makes sense.

•  Teachers who only know “lecture mode”:  “Why should I 'ask' questions?  That would be preposterous!  I’m teaching these people, not the other way around.”

•  The chef who only cooks chicken one way:  “Grilling is the only way to handle chicken!  Who would want to fry, roast, sauté, stir fry or otherwise defile the meat?”

In the same way, some traders have their ideas about the only way to design a system.  “Only computerized trading is worthwhile,” or, “All the monster big traders are intuitive; nothing else really works.”

In fact, successful traders use all types of systematic trading styles.  The only critical similarity is that they HAVE a system!

A System Is a System Is a System

A couple of years ago, I wrote a series of articles on systems that I believe get to the heart of the debate about mechanical versus non-mechanical strategies.  There are lots of folks who think the only true type of system is a mechanical one.  In reality, most traders use systems that are some combination of mechanical and non-mechanical. 

Before we look at various ways to implement a rule-based systematic approach to trading, we need a working definition of systematic trading.  I believe that systematic trading is any trading strategy that follows a defined a set of rules.  I can hear the cringes out there now, so bear with me while we explore some of the subsets of systematic trading.

Purely Computerized Trading

This is any strategy that can be programmed and executed via computer.  For some diehard adherents, this is the only “true” systematic approach.  But that is a very constrictive statement and a very limiting belief about systematic trading.

Mechanical Trading

In this subset of systematic trading, the rules are completely mechanical (all decisions are either “yes or no”), but some of the rules may be difficult or impossible to program. In this style, one might have rules about the answers to  questions like, “Is there significant news on this stock?” or, “Has Market Profile shown time/price contraction?” If the questions have a binary “yes or no” answer, then the system is purely mechanical in both design and application.

Let's  stop and add a definition here, one that makes mechanical traders wince.  A rule can be a decision that requires trader input.  And, to be honest, I know many more traders who have rule-based systems that aren’t purely mechanical than those that are (more on this next week).

What’s an example of a rule that isn’t mechanical?  There are plenty: What is the current market sentiment?  How is this sector doing compared to three others?  How does this pattern compare to the last time I saw it?

Hybrid Mechanical/Rule-Based Trading

I added this category, which is a combination of mechanical rules and rules that require a trader’s input, because lots of traders use this style of systematic trading—more than any of the others.

Rule-Based, Non-Mechanical Trading 

This is a style where a trader follows rules, and follows them every time, but those rules aren’t a mechanical set.  My belief is that most successful intuitive traders fit into this category.  They have rules that they follow, but they just haven’t formalized them in a way that a linear/logical thinker would understand.

So, What’s the Best Systematic Trading Style?

After reading this list of systematic trading subsets, many folks will ask which one is best.  In reality, there is no single right answer.  The many traders I’ve gotten to know over the years, however, have provided me this important insight: the two extremes are the most difficult to sustain over time. 

Traders who use purely computer-based rule sets are few and far between.  The constant “care and feeding” of a purely computer-based mechanical system practically requires a staff. 

At the other end of the spectrum, successful traders who are purely intuitive or discretionary are rare as well.  The few traders that I’ve met who claim to be discretionary almost always have a very clear rule set, even if they don’t realize it and it only takes a few questions to uncover some of those rules.

Most traders I’ve worked with use a style that’s somewhere in between—hybrid mechanical plus rule based trading would fit most of the traders that I know.  This seems to be the style range that works best for most traders

One bit of personal advice for new traders or those trying a new trading style (different timeframe, instrument, etc.): it is easier to start with a more mechanical approach, especially when learning to deal with the emotions and psychology of the game.  That’s why we emphasize more mechanical strategies (while also adding in some intuitive nuances) in our upcoming swing trading workshop.

I firmly believe that all successful traders need a rule set that they follow consistently.  Through experience, natural ability and self-mastery, traders can choose to widen the latitude of their rules over time.  The important conclusion here is that you, as a trader, identify a trading style that fits you best.  If neither two minute trades all day in front of a screen nor coding software for a mechanical system seems appealing, then swing trading might  be an appropriate trading style for you. As I alluded to earlier, the swing style seems to be one that works best for many traders because these systems encompass a broad range between hybrid mechanical to simple rule based trading.

In about 10 days we are offering Tactical Pro Swing Trading for the first time. My good friend and market expert Christopher Castroviejo and I will be teaching a number of easy to learn swing systems in depth. We’ll show you the tactics that Christopher and I have developed and used in a combined 60+ years in the markets. We add in the street smart savoire faire we've acquired to the mechanical strategies. We also have a great section on using options in swing systems that can add a great tool to your toolbox. In addition, we’re teaching a fourth day completely dedicated to band trading.

Understanding what trading style fits you is one of Van’s key tenets for successful trading.  Spending time understanding yourself and your trading style is an important part of every trader’s journey.  Join Christopher and me to explore some profitable swing methods—a number of which will fit you!  We look forward to seeing you there!

Great trading,

D. R.

About D.R. Barton, Jr.:  A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena.  He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at  "drbarton" at "iitm.com". 

Trading Tip

Gold Analysis & Strategy

September 2009

By 

Florian Grummes

My name is Florian Grummes. I live in south Germany and am a self-employed independent professional trader and investor in the gold market. I started focusing on this market in 2003 after listening to one of Van’s programs in which he discussed the DOW/Gold Ratio.

I write this gold market update every two weeks to have an ongoing trading plan that guides my trading in the gold market. As I learned from Van, we trade only our own beliefs about the market. Therefore, please be aware that this report represents, and is based on, my own beliefs about the markets and gold. This analysis is meant to be an educational service for you and does not represent a recommendation for any kind of investment. If you have any questions, feel free to email me at florian.grummes AT web.de. Also, if you want to sign up for my free newsletter, drop me an email.

 1. Gold spot price Analysis

1.1. Gold in USD (one ounce = US$993.40)

As expected in my last analysis, the breakout of the triangle finally happened last week. Although the level of US$1,000, as well as the all-time high at US$1,037, has yet to be reached, the market made a clear statement. I am pretty sure that this was the next strong up-move in the long term gold bull market that everybody was waiting for. Only a pullback below US$980 would negate this positive picture. 

I would like to review the last big rally in gold during 2007/2008 to give you an idea about what we can expect until spring in the gold market.

Gold topped out at US$730 in May 2006. During the next fifteen months, it failed four times at the US$690 level. After a short but tricky pullback down to US$640, gold finally broke through the US$690 level in mid-August 2007 and started a huge rally. Despite overheated short term indicators gold went straight up to US$744 without any correction! The first pullback was less than US$20 back to around US$720 and lasted for 2 days! The second small correction was from US$770 to US$742, and it only lasted 3 days. All the shorts got smashed during this time. 

The first real correction happened in early November at US$844 and took Gold down to US$770 again. The following consolidation in the form of a triangle lasted for six weeks, but in mid-December the bulls took over again and gold went straight up until mid-March 2008 to US$1,037. It is very interesting to note that both of the important levels at US$844 and US$1,037 are the exact 161.8% and 261.8% Fibonacci extensions of the previous correction.

With this information, you will understand my projection for the current rally in gold until spring 2010. The prerequisite for this scenario is that gold will not fall down below US$980 before then.

During the last three trading days of last week, gold moved up in a very strong manner. No short term pullbacks happened, which is typical for a breakout. Even if the short term indicators are overbought, we can expect that gold will run up to US$1,050 without any break! Then we should see a short pullback down to around US$1,020, and I expect another strong move up to US$1,250 in November/December. 

The US$1,250 level marks the 161.8% extension of the correction that we experienced since March 2008. At this level we should see a short but heavy pullback of approximately US$110. So this correction should go down to around US$1,140 and last a couple of weeks. During that correction all indicators will cool down and a test of the 50d MA should be in the cards. After this healthy consolidation, gold should be ready to reach the 261.8% extension at US$1,600 in spring 2010. At that point, gold will top out and create a trip to Hell for the greedy, crowd following traders and investors (with a nasty and fast correction down to probably US$1,250).

This projection, of course, is hypothetical and only time will tell the exact story. One goal is to show you that it is a very bad idea to short the market at the moment. My other goal is to show that the potential to the upside is clear. My personal experience is that one should not trade these up-moves with a short term trading approach; instead, one should keep leveraged positions with reasonable position sizing until the first bigger correction during winter appears.

All the indicators that I normally analyze in my reports are not very helpful at the moment. The 50d MA (US$944.91) and the 200d MA (US$909.27) are running parallel to the upside and really are not important right now. Because of the breakout, the Bollinger Bands are not very meaningful. This will change again, of course.

Gold seems very likely to finish its mid-term correction since the all-time high in March 2008, at US$1,037 now. To reach this price it is still necessary that it sustainably breaks through the level of US$1,000 and any pullback, (I do not expect this) within the next days should not go down below US$980.

The long term technical and fundamental perspective for gold is still very bullish. The next price targets are the Fibonacci Extensions of the complete correction from March 2008 to November 2008. This gives us the two projections at US$1,250 and US$1,600. 

The Dow Jones/gold ratio is now at 9.49, which indicates that the next rally in gold has started. For the Dow, unfortunately, it is much harder to evaluate the situation. The bear market rally that started in February 2009 might find an end soon, or at least there might be a correction during September/October. That could be negative for gold because of forced delevergaging. On the other hand, the strength of gold clearly reflects the coming meltdown in public confidence, the need for safety, transparency, and the lack of trust in governments in general. On top of that comes the news that Hong Kong is going to take its gold out of the vaults in London, and the Chinese government is encouraging its people to personally buy gold. For the well informed smart money, this isn’t really news, but it seems that most mainstream investors have just started to realize this.

Long term, I expect the price of gold to move towards parity to the Dow Jones (=1:1).  This means we are in a long term bull market in gold (and commodities) and in a secular bear market in the equity markets. However, this might take years to play out.

1.2. Gold in EUR (one ounce = 694.17€)

Also in EUR gold shot straight up and closed last week just below the 700€ level.

Everything is in place for a big rally now. Gold should conquer the 700€ level soon. The next price targets are 730€ and the high of February at 793.5€. 

The weekly MACD Indicator looks very good and gives gold in € massive room to the upside!

1.3. Gold Bugs Index USD (409.06 points)

The index of the gold mining stocks HUI already reached a new high for this year! The breakout of the triangle is obvious. Now we should see an attack of the all time high at 520 points in the next weeks and months. 

Contrary to gold itself, the mining stocks are pretty far away from their all-time high. From this perspective, there is a lot of potential.

On the other hand, the gold-mining stocks already went up more than 170% since November 2008, but if the “small” gold sector gets started and big money moves in, everything is possible. 

Below is a chart of the goldmines-index during the 1970s. Get yourself ready for a rollercoaster trip!

1.4. Gold COT Situation

The very high short position of the commercials reminds us to stay alert. This fact does not support a new big rally in gold, but because of the new rules for the future markets the few big short sellers might be forced to cover their positions. It is also very likely that the big shorts are heavily long in the option market. 

The strong up-move in gold during the last few days is not yet reflected in the numbers for this week. This Friday we will know more. 

18.04.2009 = -153.419 (PoG Low of the day = US$885 )
19.05.2009 = -183.065 (PoG Low of the day = US$920 )
26.05.2009 = -208.136 ( PoG Low of the day = US$939 )
02.06.2009 = -226.521 ( PoG Low of the day = US$970 )
23.06.2009 = -194.430 ( PoG Low of the day = US$913 )
14.07.2009 = -182.287 ( PoG Low of the day = US$917 )
04.08.2009 = -228.193 ( PoG Low of the day = US$950 )
11.08.2009 = -222.905 ( PoG Low of the day = US$943 )
18.08.2009 = -204.545 ( PoG Low of the day = US$933 )
25.08.2009 = -211.342 ( PoG Low of the day = US$939 )
01.09.2009 = -216.708 (PoG Low of the day = US$940 )

1.5. Gold Seasonality

In the past, September has always been an extremely positive month for gold. And it looks like this year is no exception. So seasonality now strongly supports rising prices. 

1.6. Gold Sentiment

The bull market feeds the bull market. Most market participants do not see the potential of the gold market yet. Yes, the sentiment is very positive but only hardcore gold bugs expect a 50% rally within the next few months. As I mentioned in the last issue, it is not a good idea to stand into the way of a crazy crowd of bulls.

1.7. Conclusion 

The charts are very positive and strong rising prices are very likely. It is not too late to get on board. Besides a possible correction of the broader stock market, the high short position of the commercials and the HUI´s 170% performance since November 2008 are the only warning signals I can see at the moment.

But this time, contrary to the past, a correction in the stock market might drive even more people into the gold market. Every weekend some US-banks are going bankrupt. Hyperinflation is the sure final outcome. In this environment, who can you trust? Only precious metals in your hands!

2. Recommendations

• A must read: Martin Armstrong  Money Talks

• Hyper-Inflation in Weimar, Germany

About the Author: Florian Grummes (born in 1975 in Munich) has been studying and trading the Gold market since 2003. Beside a lot of self-development workshops and seminars his experience in the gold market comes from trading and investing his own money to finally become a very successful self-employed precious metals trader and investor. Along with his trading business, he is also a very creative and successful composer, songwriter and music producer.

Disclaimer

 

Wow, Big Price Discount On Dr. Tharp's TWO MOST IMPORTANT Workshops

• Blueprint for Trading Success, Monday-Wednesday, October 12-14

• Peak Performance 101, Friday-Sunday, October 16-18

• Dinner at Dr. Tharp's Home, Wednesday, October 14th

Reader Feedback

Evidence of Secular Bear Market

Q: Van talks a lot about being in a secular bear market, but what evidence do we have that this is the case or what is this belief based on?
Kind regards, Paul

A: Secular bear means that PE ratios go down over a long period of time. What evidence is there? Look at the PE ratios on the S&P 500 since 2000.

Ed Easterling's research on the markets is probably the best evidence for it. His book is called Unexpected Returns. Also Michael Alexander's book, Stock Market Cycles is excellent.

Now the unusual thing about secular bear markets is that often the fundamental conditions are not that bad. However, the fundamental conditions of the US economy (and Europe too) is the worst I've seen in my 63 years. It was much better at the end of WWII when I was born. — Van

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