T2W Trading Community

Step 4: Evaluate your day trading system
The 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 day trading system shows a loss; try to reverse your entry signals. On our website 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 day trading worthwhile. Day trading is all about risk and reward, and you want to make sure you get a decent reward for your risk.

Take a look at 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 day trading 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 day 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 day trading system with a high number of trades per month. Many profitable day 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 day trading 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 day trading system. Why doubling? Remember: your worst drawdown is always ahead of you. 
• 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 system
There is a difference between “improving” and “curve-fitting” a system. You can improve your day trading 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 at the net profit only; 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. Simple 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 day trading 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.