Developing a trading system that fits your personalityasr: I have saved a 'Trading business plan in google docs , check there 'IntroductionAfter seeing the number of excellent discussion threads on FF, I thought I'd give this a shot. I've been trading for 16 years (full-time for the last three) in the equities & equity options markets and now Forex as well for the last four. I got the trading bug from working in the financial industry designing and developing computer systems and often working in direct contact with traders in the electrifying atmosphere of the trading floor. I started out knowing nothing about trading and initially got my rear-end kicked a number of times until I realized I had to treat this endeavor like a business if I wanted to have a chance in the long run. Why would an otherwise sane person step into a ring with a black-belt thinking they've got a chance past a lucky quick shot (read successful single trade)? When you take a position in a market, there are plenty of pros out there who will be happy to take your money if you don't know what you're doing.
Today, trading comes "fairly" easily as do the profits. And while I've improved as a trader, the number of inquiries from people regarding my trading style and how I develop systems has increased as well. I hope to cover some of these questions here as it relates to (mostly) system development.
Most everything I've learned about trading, I picked up from someone else at some point and then adapted into my own style of trading and I'd like to now help others. "A candle loses nothing lighting another candle" as the saying goes if I may be so bold as to assume I've got something worthwhile to pass on to others. For starters, I've learned (the hard way) that the
success formula looks something like: Quality Input + Hard Work + Discipline + Some Originality = Success in trading -- or any other business. While this may be old hat for the seasoned traders on FF, if you're just starting out,
be aware that no matter how much you learn from other people, no one will be able to do the hard work for you, especially in the key areas of trading psychology and discipline -- and one could argue the latter is an integral part of one’s psychology as well although I like to separate the two out for practical purposes.
So, what I'd like to do here is first go over some background info on trading itself (as I understand it) to give this topic a proper backdrop without which even the "best" trading system will fail, so hang in there for a bit. Then we can discuss what goes into developing a trading system that suits your trading style, i.e. something you're comfortable with and know inside out that you can then ultimately stick with in the market(s).
Thoughts on the business of tradingLet me cut to the chase as to what trading is -- or at least what I believe it to be. It's often said that the three most important things in real estate are location, location, location. In a similar fashion, the top three criteria a trader needs to master to become successful are discipline, discipline, discipline. This doesn't sit well with some of the folks I've tried to coach in the past. What everyone is after are the killer setups and/or the magic indicator. The forums abound with people starting out in trading suffering from “indicatoritis”: everyone's after the one indicator (or combination of indictors) that will tell them exactly when to buy and let them know when the very top of a bull run has been reached so that they can be the first to get out of a position as well. So, my message is often met with disappointment as the word discipline sometimes makes some would-be trader uncomfortable. Let me expand on what I mean by discipline as it relates to trading:
1. The discipline to do one's homework before putting money on the line. This includes learning about the tools (trading s/w, indicators, trendlines, Fibanocci #'s, etc.) even if you choose not to use some of these. There’s something valuable to be found in each of these and they will help you get a better feel for the markets.
2.
The discipline to find out what market(s) to trade. Bonds, equities, forex, futures, ...? or some form of derivatives (e.g. options)? Or maybe multiple markets? Each has distinct advantages/disadvantages and idiosyncrasies you need to be aware of.
3.
The discipline to find the timeframe(s) that's suited to your lifestyle and temperament. Daily charts behave differently from 5 min charts and your trading style will likely have to be different as well.
4.
The discipline to find a trading system or methodology one knows inside out and is very comfortable with. Ideally, it should be custom built so as to suit the trader's personality (more on this later). That said, there are some great systems out there for sale or even for free that might do the trick for you.
5. The discipline to follow one's trading rules to get in and out of the market(s).
6. The discipline to learn about money management and position sizing (e.g. how many shares/lots should I buy/sell?)
7. Last, but not least, the discipline t
o keep an extensive trading journal.
If you do your homework, you'll come to have a healthy respect for the markets which will save you from reckless trading. You'll also likely start to treat trading as a business, which you should. All things being equal, profits will then come fairly easily. If you lack in any of these areas, you'll keep on struggling and wonder why you're not getting ahead. What's often frustrating in trading is that what you think is holding you back might in fact have little to do with the actual problem (a big topic on its own). If you're stuck for a long time or if you just want to speed the learning process along, a mentor can be of invaluable help.
So, how do you acquire the necessary discipline? In one word: determination. In my case, it came from watching my account balance going down continually when I first started all those years ago until the pain of losing money became so great that I decided to learn whatever I had to in order to become a successful trader. At the outset, I thought this would take me about 6 months. In reality, it took me three years of tribulations and lots of sweat to become profitable -- and I'm still learning every day. That’s the kind of determination it takes to succeed but it would appear that most unfortunately give up too quickly maybe because at the outset they didn't develop a proper plan -- a proper business plan.
Business PlanSo, if you have a good handle on points 1 through 3 from the last post, you should have some of the basic components for your business plan. Put down on paper what you know so far. This is a powerful little exercise that will add clarity in your mind as to your ultimate goal of becoming a successful trader and ensure you have a solid trading plan. Later, once you have an actual trading system in hand, you can add it to your business plan.
What should go into your business plan? You can google the subject for more details (for example “The Trading Plan by Linda Bradford Raschke “ and “Kane Trading on The Difference Between a 'Plan for a Trade' and the 'Trading Plan'” amongst others) and I won’t repeat what these and other excellent articles cover, but at least the following should be in an early draft of your business plan at this stage:
1. System goals. What are the criteria for the system you’re going to select/create? Yes, I know: “It should make lots of money”, but we’re after more details here. What kind of a system are you looking for? For example, how often should it give you a signal, what should the ideal profit factor and recovery factor be? how about winning %? In other words, what would an ideal (and realistic) system look like? Lots to think about here.
2.
What markets? what timeframe? Why? 3. While the above cover portions of the trading plan, in my mind a business plan should also make a business case: i.e. why choose this business? what makes you believe the time invested will be worthwhile vs. starting another business you may ultimately be more suited for?
1. and 2. should help narrow down the list of the myriad of potential systems out there. I'm trying to squeeze a lot of information in just a few lines, so if there are any questions, please let me know.
Another key component in determining what trading system to choose: your personality.
Your personalityComing back to a point I alluded to earlier. Your system needs to suit your personality. While I believe that most people have to change some of their habits to become successful traders, we still all have different personalities, different strengths and weaknesses and we will behave differently within a same market -- that’s what makes a market after all. The key here is “know thyself”.
Are you aware of your own tendencies and idiosyncrasies? I would recommend taking a personality test of some sort if you’re unsure, ideally geared towards analyzing your behaviors as it relates to trading. Knowing you're INTP for example isn't specific enough. Better find out now than when you’ve drained your account and realize you need to go back and do this. As the old saying goes (credited to George Goodman afaik), “If you don’t know who you are, the stock market [or any other] is an expensive place to find out.”
I recently took such a test with the Van Tharp institute (another excellent source of info btw) during a beta test and the final test might be available online now. Even if it costs a bit of money to take this or another test, do yourself the favor and find out what your strengths and weakness are. This is one of the best investments you can make. You may even find out about some weakness that you weren't consciously aware of. And that will help you tremendously.Journal Logging of TradesBefore you think I'm a stickler for the kind of work the last few posts require, I used to be the type of guy that tends to say “yeah, whatever...” skipping over the type of stuff I wrote above just to get to the meat of the topic, thinking I'm smart enough, know myself enough etc that I don’t need to do any of this. The fact is what it would be very hard for anyone to keep all this information above straight in just one's mind, especially at the level of detail these topics require.
Writing things down allows you to cross-reference ideas, give them clarity and go into much more detail than would otherwise be possible. Think of it as a blue-print. If properly designed, the journey to achieving your goals will be much simpler and pleasant. Ultimately, it’s a time saver even though it doesn’t seem so at the outset. How I wish I would have known this a few years ago, but that’s another story...
Picking a system - 1. Personal CriteriaIf you’ve done the exercises above, you’ve covered one of the dimensions necessary to find a suitable trading method. At the risk of repeating myself because this is a key point: whatever system you pick, it has to fit your personality / preferences in the following areas so that you’ll actually be able to trade the system especially during tough market conditions:
*
Type of system: I’ve only encountered three in my career: 1) trend following (sometimes trend anticipating), 2) volatility based and 3) breakout based (or combinations of these. if anyone knows of any other type, please let me know) If you’re new to trading, you may not know yet which to pick and that’s fine. Again, try to get exposure to all three to find which you’re drawn to and have an idea what methodologies other traders are using. For example, expect larger drawdowns in trend following systems. If there’s interest, I can provide further information on advantages and disadvantages of each type of system in a subsequent post.
* How often the system trades, sometimes
referred to as the Opportunity Factor.
asr: one way define it as #time/month => for OIL Oppertinity factor= 2/month for good LOW risk trades * How smooth should be equity curve be? A more erratic (volatile) one may be more profitable, but will you be able to trade it? This also ties into the drawdown. What is the avg (and max) drawdown of the system you’re considering using? Are you comfortable with that number?
* Winning %. Be careful here. I’ve seen many systems tout a high percentage but that number in meaningless if you don’t know what the average winner will bring you and the average loser cost you. Keep in mind that the Expectancy (profit per avg trade) is equal to the (Winning % × avg win) – (Losing % × avg loss). So, is a higher number better? Overall yes, as long as you’re comparing systems over the same (and long enough) time period.
* If you’re trading Forex, you probably don’t have any market direction preference, but be aware that some systems do.
Picking a system - 2. System RequirementsSome absolute system properties, no matter which you choose:
*
Profit Factor: this is the system's Gross Profit divided by Gross Loss. Look for systems that have a Profit Factor of 2 or higher. (from Wealth-Lab’s help)
*
Recovery Factor: it is equal to the absolute value of Net Profit divided by Max Drawdown. Recovery Factor should typically be larger than 1. A healthy Recovery Factor is an indication that a system can overcome a drawdown. (from Wealth-Lab’s help)
*
Payoff Ratio: this is the absolute value of the system's average profit per trade divided by the average loss per trade. Unless the system has a particularly high Win/Loss ratio, we look for high Payoff Ratios. (from Wealth-Lab’s help)
* For more experienced traders another question is: should the system be 100% mechanical? Or do you want to allow for some discretion as well? If so how much and under what conditions? For example: because I’ve been looking at charts for a while, I have developed a feel for the markets I trade and the system
I use in one of my accounts is based on MAs and their interpretation is often subjective. This is a hybrid system that works fine and I use it when I happen to be at the computer trading live.
So, in short, the system has to be sound, in other words an existing should have been profitable over the long run in whatever market(s) you choose to trade. Some people say the testing period should include at least x number of time periods, others x number of trades.
My own inclination for e.g. a new daily trading system I devise is 5 years of daily data plus stress testing before roll-out.AnalysisNow that we’ve had an overview of the different aspects and types of systems, let’s come back to the personality characteristics. Our own personality analysis should cover key areas such as:
1. objectives
2. personal strengths
3. personal weaknesses
4. beliefs about the market
5. valuesIf you have trouble coming up with a list for these categories, try doing a “brain dump”. Write down 100 brief statements about e.g. your values as quickly as you can without giving thought to grammar. After a while, you should see patterns emerge.
Also, for more help, have a read through the myriads of articles by Brett Steenbarger as well as his book; he’s another leading authority in the area of trading psychology along with the Van Tharp institute I mentioned earlier. There also used to be a brief personality test on his website.
Let’s take a simplified version of what a fictitious trader has come up with and try to determine what kind of system we could build or recommend for him/her.
1)Objectives * To trade once a day
* To grow the account at a steady pace achieving 20% return per annum
* To not take undue risk (even at the expense of foregoing maximum profit)
2)Strengths * Strong analytical skills
* Highly motivated (greatly interested in the subject of trading)
* Flexible in the type of trading system (or combination of trading systems)
3)Weaknesses (or “challenges” if you prefer) * Tendency to jump ahead of trades
* Sometimes make being “right” a stronger motivator than getting out of a losing trade
* Often close a winning trade prematurely out of fear of losing potential profit
4)Beliefs * The market moves in discernable long-term cycles.
5)Values * Money is a limited resource. It should be dealt with carefully.
Note: a real analysis should be longer and more in-depth but for simplicity sake, I’ve kept this list brief.
What kind of system could we propose for this trader?
----------------
How to Develop a Profitable Trading System
by Rockwell TradingTrading Systems Coding: System Design -- good page here
In this article we will explain to you how to develop a profitable trading system in five steps:
Step 1: Select a market and a timeframe
Step 2: Define entry rules
Step 3: Define exit rules
Step 4: Evaluate your system
Step 5: Improving the systemLet's take a closer look at these steps.
Step 1: Select a market and a timeframeEvery market and every timeframe can be traded with a system. But if you want to look at 50 different futures markets and 6 major timeframes (e.g. 5min, 10min, 15min, 30min, 60min and daily), then you need to evaluate 300 possible options. Here are some hints on how to limit your choices:
· Though you can trade every futures markets, I recommend that you stick to the electronic markets (e.g. e-mini S&P and other indices, Treasury Bonds and Notes, Currencies, etc). Usually these markets are very liquid, and you won't have a problem entering and exiting a trade. Another advantage of electronic markets is lower commissions: Expect to pay at least half the commissions you pay on non-electronic markets. Sometimes the difference can be as high as 75%.
· When you select a smaller timeframes (less than 60min) your average profit per trade is usually comparably low. On the other hand you get more trading opportunities. When trading on a larger timeframe your profits per trade will be bigger, but you will have less trading opportunities. It's up to you to decide which timeframe suits you best.
· Smaller timeframes mean smaller profits, but usually smaller risk, too. When you are starting with a small trading account, then you might want to select a small timeframe to make sure that you are not overtrading your account.
Most profitable trading systems use larger timeframes like daily and weekly, but be prepared for less trading action and bigger drawdowns.
Step 2: Define entry rulesLet's simplify the myths of "entry rules": Basically
there are 2 different kinds of entry setups:
· Trend-following: When prices are moving up, you buy, and when prices are going down, you sell.
· Swing-trading: When prices are trading at an extreme (e.g. upper band of a channel), you sell, and you try to catch the small move while prices are moving back into "normalcy". The same applies for selling.In my opinion swing trading is actually one of the best trading styles for the beginning trader to get his or her feet wet. By contrast, trend trading offers greater profit potential if a trader is able to catch a major market trend of weeks or months, but few are the traders with sufficient discipline to hold a position for that period of time without getting distracted.
Most indicators that you will find in your charting software belong to one of these two categories: You have either indicators for identifying trends (e.g. Moving Averages) or indicators that define overbought or oversold situations and therefore offer you a trade setup for a short term swing trade.
So
don't become confused by all the possibilities of entering a trade. Just make sure that you understand why you are using a certain indicator or what the indicator is measuring. An example of a simple swing trading strategy can be found in the next chapter.
Step 3: Define exit rulesLet's keep it simple here, too: There are two different exit rules you want to apply:
· Stop Loss Rules to protect your capital and
· Profit Taking Exits to realize your profits
Both exit rules can be expressed in four ways:
· A
fixed dollar amount (e.g. $1,000)
· A percentage of the current price (e.g. 1% of the entry price)
· A percentage of the volatility (e.g. 50% of the average daily movement) or
· A time stop (e.g. exit after 3 days)I don't recommend using a fixed dollar amount, because markets are too different. For example,
natural gas changes an average of a few thousand dollars per day per contract; however, Eurodollars change an average of a few hundred dollars a day per contract. You need to balance and normalize this difference when developing a trading system and
testing it on different markets. That's why you should always use percentages for stops and profit targets (e.g. 1% stop) or a volatility stop instead of a fixed dollar amount.
A
time stop gets you out of a trade if it is not moving in any direction, therefore freeing your capital for other trades.
Step 4: Evaluate your systemThe first figure to look for is the net profit. Obviously you want your system to generate profits. But don't be frustrated when during the development stage your trading system shows a loss; try to reverse your entry signals. On our website www.rockwelltrading.com you already learned that trading is a zero sum game: So if you are going long at a certain price level, and you lose, then try to go short instead. Many times this is the easiest way to turn a losing system into a winning one.
The next figure you want to look at is the average profit per trade. Make sure this number is greater than slippage and commissions, and that it makes your trading worthwhile. Trading is all about risk and reward, and you want to make sure you get a decent reward for your risk.
Take a look a
t the Profit Factor (Gross Profit / Gross Loss). This will tell you how many dollars you are likely to win for every dollar you lose. The higher the profit factor the better the system.
A system should have a profit factor of 1.5 or more, but watch out when you see profit factors above 3.0, because it might be that you over-optimized the system.Here are some more characteristics you might want to consider besides the net profit of a system:
· Winning percentage
Many profitable trading systems achieve a nice net profit with a rather small winning percentage, sometimes even below 30%. These systems follow the principle "Cut your losses short and let your profits run". However, YOU need to decide whether you can stand 7 losers and only 3 winners in 10 trades. If you want to be "right" most of the time, then you should pick a system with a high winning percentage.
· Number of Trades per Month
Do you need daily action? If you want to see something happening every day, then you should pick a trading system with a high number of trades per month.
Many profitable trading systems generate only 2-3 trades per month, but if you are not patient enough to wait for it, then you should select a system with a higher trading frequency.
· Average Time in Trade
Some people get really nervous when they are in a trade. I have heard of people who can't even sleep at night when they have an open position. If that's you, then you should make sure that the average time in a trade is as short as possible. You might want to choose a system that does not hold any positions overnight.
·
Maximum Drawdown
A famous trader once said: "If you want your system to double or triple your account, you should expect a drawdown of up to 30% on your way to trading riches." Not every trader can stand a 30% drawdown. Look at the maximum drawdown the system produced so far, and double it. If you can stand this drawdown, then you found the right system. Why doubling? Remember: your worst drawdown is always ahead of you.
asr: this is true in OIL, we need to withstand 15-20% darwdown so that means for $10,000 account $2k draw down so for $10k account we can only trade 1 mini crude so that is $1k loss per trade.· Most consecutive losses
The amount of most consecutive losses has a huge impact on your trading, especially when you are using certain types of money management techniques. Five or six consecutive losses can cause you a lot of trouble when using an aggressive money management.
In addition this number will help you to determine whether you have enough discipline to trade the system:
Will you still trade the system after you have experienced 10 losses in a row? It's not unusual for a profitable trading system to have 10-12 losses in a row. Step 5: Improving your systemThere is a
difference between "improving" and "curve-fitting" a system. You can improve your system by testing different exit methods: If you are using a fixed stop, try a trailing stop instead. Add a time stop and evaluate the results again. Don't look only at the net profit; look also at the profit factor, average profit per trade and maximum drawdown. Many times you will see that the net profit slightly decreases when you add different stops, but the other figures might improve dramatically.
Don't fall into the trap of over-optimizing: You can eliminate almost all losers by adding enough rules. Example: If you see that on Tuesdays you had more losers than on the other weekdays, you might be tempted to add a "filter" that prevents your system from entering trades on Tuesdays. Next you find that in January you had much worse results than in other months, so you add a filter that enters trades only from February – December. You add more and more filters to avoid losses, and eventually you end up with a trading rule that I saw recently:
IF FVE > -1 And Regression Slope (Close , 35) / Close.35 * 100 > -.35 And Regression Slope (Close , 35) / Close.35 * 100 < .4 And Regression Slope (Close , 70) / Close.70 * 100 > -.4 And Regression Slope (Close , 70) / Close.70 * 100 < .4 And Regression Slope (Close , 170) / Close.170 * 100 > -.2 And MACD Diff (Close , 12 , 26 , 9) > -.003 And Not Tuesday And Not DayOfMonth = 12 and not Month = August and Time > 9:30 ...
Though you eliminated all possibilities of losing (in the past) and this trading system is now producing fantastic profits, it's very unlikely that it will continue to do so when it hits reality.
ConclusionDeveloping a trading system can be tricky, but it's by far not as complicated as many vendors make you think. The purpose of this eBook is to give you an overview about the different steps of trading system development. Make sure to apply the "10 Power Principles of Successful Trading Systems" when developing and evaluating a trading system:
http://www.rockwelltrading.com/trading_system_step_2.htm
(edited by finance professor Greg Gregoriou): "Volatility is an inevitable market experience mirroring 1) fundamentals, 2) information, and 3) market expectations. Interestingly, these three elements are closely associated and interact with each other."
