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Developing Your Own Trading System

Sunday, 28 January 2007

Perhaps the biggest single mistake investors make when they begin to analyze the market is that they fail to put together a trading system. An analysis procedure is not a trading system. Most traders are attracted to technical analysis because they use or are exposed to a technique, such as moving averages or chart formation analysis, that works. They then want to apply this specific technique to every situation. Perhaps the biggest single mistake investors make when they begin to analyze the market is that they fail to put together a trading system. An analysis procedure is not a trading system. Most traders are attracted to technical analysis because they use or are exposed to a technique, such as moving averages or chart formation analysis, that works. They then want to apply this specific technique to every situation. DEVELOPING YOUR OWN TRADING SYSTEM All technical tools described have been used to successfully trade the futures markets at one time or another, but there are many, many technical approaches. Apartial list might include astrological, complementary angles, Harahus pentagon, Japanese candlesticks, par- abolic, point and figure, price bar congestion, speed resistance lines, stochastics, and swing charts. However, neither a single technical analysis tool nor a combination of analysis tools makes up a trading system. Analysis is only a part of a trading system—often a small part! True trading systems are composed of three major components. The first and most important is a money management technique. The second is the analysis of the market, and the third is a market input-output mechanism. Consider the following guidelines for selecting an analysis system. 1. Choose an analysis procedure, or better yet, a series of analysis procedures, in which you have a high level of confidence. 2. Pick a system that is qualifiable and quantifiable. It must be specific and tell you to go long or short and at what price. 3. Be sure your procedures are able to withstand serious, historical testing. You must be able to use historical market data and to run simulations that can be done quite easily on today’s personal computer systems. 4. Choose optimizable analysis procedures. This will help avoid using yesterday’s factors for tomorrow’s markets. Optimizing is a fine-tuning procedure. It does not mean abandonment of analysis principles. Optimizing adjusts your analysis procedures based on a change in market conditions, such as a major change in market volatility, not just a change in your opinion. 5. Make sure the analysis procedure tells you when to get into a trade and when to get out. Computer-based systems work better than systems that are difficult to computerize. Computers take much of the opinion out of decision making and allow more accuracy in determining historical track records and hypothetical performance. DANGERS OF LIQUIDITY As you test trading systems, the accuracy of your hypothetical results will depend a great deal on how closely your projected entry and exit prices resemble reality. When testing futures market trading systems, it is common to add an extra cost factor of $100 per trade to cover slippage and brokerage commissions. The degree of slippage depends on liquidity and the spread difference between bid and ask prices. For grains such as soybeans, where high liquidity typically exists, slippage for an individual trade may only be a quarter of a cent per bushel or $12.50 per 5,000-bushel contract. But in less actively traded markets, such as orange juice, slippage may be as much as $200. MATCHING MONEY MANAGEMENT WITH ANALYSIS Money management is a primary concern. You can’t trade successfully if your system constantly drains your trading account of equity. Successful traders talk about the necessity of surviving the rough, choppy markets so that they are in a position to profit when the market smoothly trends up or down. To succeed, you must first survive. Surviving simply means preservation of risk capital. You must be able both financially and psychologically to withstand some losing trades. You should cut your losses quickly and let your winners run. The trading system you select or develop should have a definite procedure for protecting positions with stops or “bailout” points. Money management may well be more critical than the analysis facet of the trading system. Even the best analysis procedure is seldom more than 50 percent right. Good money management preserves your chips when the analysis is wrong. It should provide readouts of risk-to-reward ratios. Know your trading limits. If you can select the correct amount of money to trade that suits your emotional makeup, you can reduce the negative influence of greed. At the same time, you need to invest enough to make the risk taking involved in the futures markets worth your while. It’s common for beginning traders to overtrade. They often select markets that are cosmetically exciting and require large margins. Gold and silver are popular choices. Equally common are the nervous Nellies who invest too little. They have not fully accepted the concept of futures trading. If traders only stick one toe in the wa- ter, investing 1 or 2 percent of their risk capital, a doubling of their money makes little impact. There are a number of formulas for selecting the proper risk capital that should be devoted to high-risk investment opportunities. The following formula has proved to be effective. First, determine your net liquid assets (NLA). NLA include assets that are cash or can be converted to cash within 24 hours. These are savings accounts, CDs, common stocks, etc. They would not include real estate, life insurance policies, IRAs, etc. Once the NLA have been determined, no more than 10 percent of this capital should be earmarked for high-risk situations. For example, if an individual has net liquid assets of $50,000, the amount of investment capital will be 10 percent, or $5,000. This is the smallest investment recommended to a beginning commodity trader. Some informal studies have indicated that the larger the amount of investment capital placed in commodity trading, the greater the chance for success. The rough percentages are as follows: With $5,000 in a commodity trading account, the probability for success after 1 year is approximately 1 out of 10. With $10,000, it is 2 out of 10. With $20,000, it is 3 out of 10. With $50,000, it is 50–50. With $100,000, it is 6 of 10. Notice that the odds are stacked against the trader with less than $50,000 in an individual commodity trading account. This certainly heightens the importance of good money management techniques. The success ratio improves for two reasons as the investment capital available increases. The first is diversification. The more money in an account, the more markets you can test. The more markets you are in, the more likely you’ll be in a market that makes the big moves. The second reason is staying power. If you have a very small amount to invest, you may only have enough equity for one or two trades. The odds get better of hitting a winner when you have enough money to make 15, 25, or 60 trades.