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:

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.

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.

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, there 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.

Strategies and systems are at the core of what we do as traders. But they are most useful when we understand their inner workings and how they fit into our whole trading plan. When you integrate a system that fits you and matches the market conditions into your trading plan, it can be a real thing of beauty. All the best in your trading!

 

About the Author: A passion for the systematic approach to the markets and a 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. D.R. is a regular contributor to Tharp’s Thoughts trading newsletter.