IV. Technical Trading Systems

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What is a Trading System?

A trading system is a set of rules that defines conditions required to initiate and exit a trade. Usually, most trading systems have many parts, such as entry, exit, risk control, and money management rules. The rules of a trading system can be implicit or explicit, simple or complex. A system can be as simple as 'buy sweaters in summer', or 'buy when she sells'. By definition, the system must be feasible. Ideally, the system accounts for 'all' trading issues, from signal generation, to order placement, to risk control. A good way to visualize effective system design is to stipulate that someone who is not a trader must be able to implement the system. In practice, every trader uses a system. For most traders, a system could really be many systems. It could be discretionary, partly discretionary, or fully mechanical. The systems could use different types of data, such as 5-minute bars or weekly data. The systems may be neither consistent nor easy to test; the rules could have many exceptions. A system could have many variables and parameters on the same market. You can trade different parameter sets on different markets. You can even trade the same parameter set on all markets. It should be clear by now that there is no single universal trading system. Every trader adapts a 'system' to his or her style of trading. However, it is possible to draw a distinction between a discretionary trader and a 100% mechanical system trader.

Why should you use a Trading System?

The most important reason to use a trading system is to gain a 'statistical edge'. This often-used term simply means that you have tested the system, and the profit of the average trade - including all losing and winning trades - is a positive number. This average trade profit is large enough to make this system worth trading - it covers trading costs, slippage, and is, on average, likely to perform better than competing systems.

Another reason to use a trading system is to gain objectivity. If you are steadfastly objective, you can resist the siren call of news events, hot tips, gossip, or boredom. Suppose you are a chart trader and you enjoy some flexibility in interpreting a given chart formation. It is very easy to identify a pattern after the fact, but it is rather difficult to do so as the pattern evolves in real time. Hence, analysis can paralyze you, and you may never make an executable trading decision. Being objective frees you to follow the dictates of your analysis.

Consistency is another vital reason to use a trading system. Since the few rules in a trading system are applied in precisely the same way each time, you are assured of a rare consistency in your trading. In many ways, objectivity and consistency go together. Although consistency is known as the hobgoblin of little minds, it is certainly a useful trait when you are not quite a champion trader.

Robust Trading Systems

A robust trading system is one that can withstand a variety of market conditions across many markets and time frames. A robust system is not overly sensitive to the actual values of the parameters it uses. It is not likely to be the worst or best performer, when traded over a 'long' time (perhaps 2 years or more). Such a system is usually a trend-following system, which cuts losses immediately and let profits run. The key feature to note is that, when systematically implemented over a 'long' time and over many markets, robust systems tend to be, on the whole, profitable. If executed correctly, they guarantee entry in the direction of the intermediate trend, cut off losses quickly, and let profits run. Countless variations of these systems exist, and trend-following systems seem to account for a large percentage of professionally managed accounts. Robust systems do not make many assumptions about market behavior, have relatively few variables or parameters, and do not change their parameters in response to market action. There is no sharp drop in performance due to small changes in the values of system variables. Such systems are worthy of consideration in most portfolios, and are reasonably reliable. In addition, they are easy to implement.