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Trading Systems – A Complex World with Simple Answers

Advances in technology have been the driving force behind the change and growth in the world of market speculation. One of the many recipients of faster and stronger technology is system trading as high speed computers now help retail and institutional traders develop systems, crunch numbers, and back test hypothetical results in seconds. In the world of professional money management, I have seen plenty of trading systems. Ironically, most don’t seem to work and of the ones that do, they typically work for a bit and then fail. Being on the education side of the industry as well, I have seen hundreds of automated systems yet, I can only say that I have seen less than a hand full actually produce a consistent profit year after year. I often get emails from people who have read an article I wrote that want to share an automated strategy with me. They are sending it so I will help them review it and perhaps improve it. Traders will send me back tested hypothetical performance reports from these strategies that suggest they have the holy grail of trading systems. Most of these will show 80% winning trades or better and huge profits. Most of the time however, when they take the next step and trade the system with real money, they lose and lose fast. With explosive advances in technology and market information, why is system trading so difficult for most who give it a try? There is a very simple reason I will discuss later. In this piece, I will focus on the foundation of a profitable trading system, offer specific tools and rules of a profitable system, and expose the dangerous traps that lead to system trading failure.

The Most Important Aspect of a System
As much change and growth has occurred due to technology, there is one component to trading that has not changed one bit and that is how the consistently profitable trader derives consistent low risk / high reward profits. The key to a proper trading strategy all comes down to the foundation of that strategy. To have the proper foundation, you must have a solid understanding of how markets work and why price moves as it does. If you have one flaw in your thought process, you can be sure it will lead to poor trading results. The reality is that markets are nothing more than pure supply and demand at work, human beings reacting to the ongoing supply/demand relationship within a given market. This alone, ultimately determines price. Opportunity emerges when this simple and straightforward relationship is "out of balance." When we treat the markets for what they really are, and look at them from the perspective of an ongoing supply/demand relationship, identifying sound trading opportunities is not that difficult a task. Market speculators who understand this simple concept and what this opportunity looks like on a price chart typically derive their income from market speculators who don’t. In other words, those who "know" get paid from those who "don’t know".

Who Is On The Other Side Of Your Trade?
If we want a consistently profitable trading system, we had better make sure that the person on the other side of our trades is a consistent losing trader. Our system had better be an expert at finding a novice trader or we are in trouble. We don’t need to know the exact person on the other side of our trade, we just need to know if they are a consistently profitable trader or a consistent losing trader, and the chart will give us most of this information.

Let’s face it, when it comes to charting and technical analysis, most active traders use indicators. While many people including myself have often beat up the indicators, they are actually a great tool when used properly for automated or semi?automated trading systems. The problem is that people tend to take every buy and sell signal an indicators produces and this is the last thing you want to be doing. Those who take each buy and sell signal an indicator offers are likely to lose their trading capital fast. It is not that the indicators are doing anything wrong. They will always do what they are programmed to do. The key for the trader is to use them in conjunction with proper trend analysis. One of the great benefits to using indicators and oscillators the right way is that they allow you to trade based on a mechanical set of rules. Let’s use a single moving average and stochastics in our attempt to use indicators in our system to find the consistent losing trader to trade with.

Above is a chart of the QQQQ. On the chart is a 50 period moving average and a slow stochastic oscillator. To begin with, we must assess the trend of prices in this market. For this task, I use a 50 period moving average. Notice that the slope of the moving average is up suggesting we are in an uptrend. Once we know this, we only want to buy pullbacks in price. The mechanical signal to buy comes when the stochastic produces a buy signal in over sold territory (moving average cross, circled above). While this turned into a nice low risk buying opportunity, notice the price action just prior to this buying opportunity in the QQQQ. During the uptrend, the stochastic was very overbought, producing sell signals during much of the uptrend which would have led to many losses had you sold short at those times. This is a trap new traders can fall into when using these tools without reality based logical rules.

Buy Rule: When the moving average is sloping upwards, take the stochastic moving average cross in oversold territory as a buy signal. When the moving average is sloping upwards, IGNORE EVERY sell signal the stochastic moving average cross in overbought territory produces.

The Reality Based Logic: When prices are moving higher, we want to find a buying opportunity when things are on sale. Most importantly, our buy signal told us objectively that someone was selling after a decline in price and selling in the context of an uptrend. This can only be the action of a novice seller. A consistently profitable trader would never sell after a decline in price and in the context of an uptrend.

On this chart, we also have a 50 period moving average and a slow stochastic oscillator. Here, the slope of the 50 period moving average tells us the trend is down. Once we know this, we only want to sell to a novice trader who is buying after a move higher in price in the context of a down trend. The mechanical signal to sell comes when the stochastic produces a sell signal in over bought territory (moving average crosses, circled above).

Sell Short Rule: When the moving average is sloping downwards, take the stochastic moving average cross in overbought territory as a sell signal. When the moving average is sloping downwards, IGNORE EVERY buy signal the stochastic moving average cross in oversold territory produces.

The Reality Based Logic: When prices are trending down, we want to find a shorting opportunity when prices are high. Furthermore, we want to sell short to the buyer who is buying after a rally in price and in the context of a downtrend (a novice buyer).

Is this or any trading system perfect? Certainly not, there is no perfect trading system and there doesn’t need to be. If there was, that person would have all the worlds’ money. However, wrapping some simple rules and logic around your trading is the key to stacking the odds in your favor. Even Las Vegas does not win all the time. They do well over time because they realize they don’t have to always win. They just need to stick to their rules that allow them to keep the edge which means betting against people who don’t have the edge.

Any Market and Indicator Will Do When You Think the Markets Correctly

This is an intra-day chart of the NASDAQ Futures with the same 50 period moving average. In this example, I simply switched the Stochastic for the Commodity Channel index, better known as CCI, we will get almost the same signals.

Technical Reason for Shorting:

1) The down sloping 50 ? period moving average suggests this market is in a downtrend.

2) A CCI Overbought reading (circled are on the chart).

Logical Reason for Shorting: Sell short to a buyer who buys AFTER a rally in price and in the context of a downtrend. The only type of mindset that would take this action is someone who makes decisions to buy and sell anything based on EMOTION, not simple and proper logic. This is the pedigree of the trader we want on the other side of our trades.

Trading strategies that work don’t change with time, markets, or changing market conditions. Quite frankly, to think market conditions ever change at all is a strong illusion that can only be removed when one focuses on the foundation of price movement, pure supply and demand. The systems I see working are very simple. The example below is an intra-day chart of the Dollar/Yen. Let’s apply our same basic principles.

Technical Reason for Buying:

1) The up sloping 50 ? period moving average suggests this market is in an uptrend.

2) A CCI Oversold reading (circled are on the chart).

Logical Reason for Buying: Buy from a novice seller who sells AFTER a decline in price and in the context of an uptrend.

Summary

Uptrend/Oscillator Overbought: Ignore
Downtrend/Oscillator Oversold: Ignore
 
Uptrend/Oscillator Oversold: Buy Signal
Downtrend/Oscillator Overbought: Sell short Signal
 

Turning Failure Into Success
I see the vast majority of traders that go down the system path spend years form-fitting indicators and oscillators based on back tested hypothetical results (numbers). I see very few people develop strategies based on the simple logic of how and why price moves as it does in any market. From my reality based market experience, trading is a simple transfer of accounts from those who don’t understand simple market logic into the accounts of those who do. Trading systems just expedite the process.

As I mentioned earlier, most traders who develop trading systems don’t take this approach or think in the simple terms I am suggesting. Why? It is because of how most people learn about markets and trading. Most will not begin their learning path as I did by handling institutional order flow on the floor of an exchange. The vast majority of market players will start with a trading book or seminar written or delivered by someone who writes books and delivers seminars, NOT a real market speculator. These books are filled with conventional use of indicators and chart patterns that simply don’t work. If they did, the author would certainly not be selling the book to you. This leads to a novice trader thinking they can take a trading system short cut and add a few indicators and oscillators to a price chart and let the computer find the parameters for each of those indicators that would have produced the best results in the past (back testing). Typically, when the novice system trader begins trading with real money based on those quality hypothetical results and begins losing money, they take the next wrong step – they begin adjusting indicator settings and worse yet, they add more indicators. This is a path that leads to trading disaster yet the novice system trader does not even know it. They say, "How can a system with such great back tested numbers not work"? It doesn’t work because the system is based on number crunching and curve fitted back testing results. The reality of how markets work is ignored. When designing your trading system, make sure you bring your foundation back to the basics of how and why price moves in any and all markets.

Sam brings over 15 years experience of equities and futures trading which began when he was on the floor of the Chicago Mercantile Exchange. He has traded equities, futures, interest rate markets, forex, options, and commodities for his personal interests for years and has educated hundreds of traders and investors through seminars and daily advisory services both domestically and internationally. Sam has been involved in the markets since 1991 both on and off the floor of the Chicago Mercantile Exchange. He has served as the Director of Technical Research for two trading firms and regularly contributes articles to industry publications. Sam is known for his trading, technical research, and educational guidance.Points of interest:• Chicago Mercantile Exchange Floor• Author of Market Advisory Letters• Fund Manager/CTA• Speaker to Investment Groups, Universities, and Private Seminars• Contributing Author for Stocks, Futures, and Options Magazine, Active Trader Magazine, and Futures Magazine• Trading and Investment Conference Speaker

Sam brings over 15 years experience of equities and futures trading which began when he was on the floor of the Chicago Mercantile Exchange. He has tr...

indicer

Newbie
1 0
Sam I like simplicity in life and your article to trade simply excellent, but I rated it 7 as I would put another couple of points if you explained what time frame you used on those charts, and what if the 50 ma looked a little horizontal on 1 min chart. and why 5 min trend looks different then 1 min trend and do you use any of these.
 

new_trader

Legendary member
6,223 1,270
To have the proper foundation, you must have a solid understanding of how markets work and why price moves as it does.

Turning Failure Into Success
I see the vast majority of traders that go down the system path spend years form-fitting indicators and oscillators based on back tested hypothetical results (numbers). I see very few people develop strategies based on the simple logic of how and why price moves as it does in any market. From my reality based market experience, trading is a simple transfer of accounts from those who don't understand simple market logic into the accounts of those who do. Trading systems just expedite the process.

Great article, but they still won't understand.
 
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nine

Senior member
2,038 506
I loved the principle but was negative about the execution - too many indicators still.

Rather than using a stoch (which is just a measure of where the close is in the (say) 6 bar range double smoothed with 5 period mas (for a 6,5,5 stoch)) it would be better to look at the price bars. How many bars is required in a good first retracement in a trend out of consolidation say? How many for second or further retracements? Do you need a signal and then a failure of that signal (generating a more reliable second signal once the first bunch get washed out)?

So, 7. Good principles but still too many indicators. New trader, I think that some will get it but they will tend to only get it - and my hints above - when they are the right stage in their learning.

Thats not meant to be arrogant but it does seem that people have to make a series of mistakes before some things become obvious. :eek:nline2lo
 
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montmorencyt2w

Senior member
2,620 294
Although I am relatively inexperienced compared to many who post here, I too think it is a great article (for what that's worth :) ). It also fits in with a lot of what I've been reading lately (and I've deliberately been doing more reading than trading just recently).

I'll throw in a naive question (aimed at the author if he is reading this and cares to reply, or else anyone else who cares to comment): What to do if the MA is flat, i.e. if it is no longer trending? (I assume the answer is "Nothing").

Thanks,
 

Rossini

Established member
916 132
Although I am relatively inexperienced compared to many who post here, I too think it is a great article (for what that's worth :) ). It also fits in with a lot of what I've been reading lately (and I've deliberately been doing more reading than trading just recently).

I'll throw in a naive question (aimed at the author if he is reading this and cares to reply, or else anyone else who cares to comment): What to do if the MA is flat, i.e. if it is no longer trending? (I assume the answer is "Nothing").

Thanks,
Yes I think nothing is the correct answer. I have found it hard and still do, but doing nothing is an essential part of trading.
 

Martinigue

Junior member
13 0
Yes I think nothing is the correct answer. I have found it hard and still do, but doing nothing is an essential part of trading.
...and I'll add one more, which is by one of the 'enlightened' traders and basically sums the last two thoughts up: "I wait until there's money lying back in the corner and then I just go and grab it; otherwise I'm doing nothing."

Doesn't trading sound just wonderful when put in that way?:cool:
 

Rossini

Established member
916 132
lol, that was the quote from Market W's that I was thinking of when I wrote that!
 

Martinigue

Junior member
13 0
lol, that was the quote from Market W's that I was thinking of when I wrote that!
Yep:clap: And I couldn't resist to throw it in ... I, for one, prefer theses advertising simplicity to the ones talking a load of monstrous systems and elaborate equations ...
 

simba00000

Junior member
12 2
Thank you and my experience with using a similar method...

First I would like to say thank you for mentioning your basic strategy/method. This is the first time I have posted anything on the net regarding trading. But I wanted to share my experience so far, since it relates to your post.

First a little about my background and experience I think would be relevant. I got into trading (mainly intaday and short term swing) less then three months ago. In the last two months I have read over 1000 pages contained in books (I still have four more books at home I have not read yet) and countless posts and sites on the net. Other then the recent trading I have done, also have purchased stocks for medium term holds in the last 15 or so years. What I think also helps me is previously I did make a good living playing Poker for about 6.5 years.

Now the real reason for my post. Almost three months ago I took $18K and opened an account to trade stocks. The reason I opened the account is because I was at a friends home and was looking at a chart of a stock (I think the stock was Intel) he was looking at and saw pretty much what you described, minus the indicators. I saw basically what you described in 15 mins looking at a daily chart. It looked really simple to me at the time. There is obviously more to trading then simple price action like Discipline, Money Management and a complete trading/action plan (which I am working on now). Here is the interesting thing about all this, so far I have made a total of 25 trades (round trips). Of which 6 have been losers, which I got out fairly quickly (either stopped out or voluntarily closed the trade) and were fairly small loses. From $18,000 start to $21,700, this trading was during a period of two months. More active now then in the beginning. I just placed another $10K in my account today to cover the minimum SEC "Pattern Day Trader margin account Minimum of $25K".

For Clarification a few key points regarding the above.

* I am a tad more cautious and get in when I think the move is already started and confirmed.

* I use MACD with Histogram, Volume and RSI

* I use Candlestick charts with a 20 day EMA. While analyzing for a trade candidate I will look at a 100 day, 50 day, 20 day, 5 day, 3 day, then yesterdays and todays (5 min) chart. Looking at all the above charts takes maybe 2 mins, generally less. I enter and exit based on intraday 1 min - 3 min charts.

* I constantly and naturally read what is going an and will read (and guestimate) what will happen. An example would be when I see a resistance or support level, based on price action, what will happen if the resistance or support level is or is not broken. Just like constantly reading people at a poker table for tells. This immensely seams to help me. Lately even the one minute charts seems to really slow down to the speed of a five minute chart. This exercise is improving my accuracy in reading the price action.

* I will short or go long, but more longs then shorts so far. If I am unsure, I just pass on the trade.

* The position sizes I have taken so far have been between $3K to $13K. With most positions between $5K - $7K.

* As mentioned above mainly intaday and short term swing trading.

* I mainly focus on Nasdaq stocks that are between $1 and $20 a share. I like the less then $12 stocks the most. A $3 stock that moves .30 cents is 10%. Only trade stocks that are liquid (at least 2.5 million shares traded a day) and provide the volatility I want.

* Generally no more then two trades in play at a time. Although I am constantly looking for opportunities.

* The platform and charting package I use is Power E*trade PRO.

Anyways, thanks again and Happy Holidays!

Chris
 

jeff2

Newbie
3 0
Thank you for this post for how to trade with the trend..
What are your thoughts on how to spot a trend change?
Thank you
 

johnnyonspot

Junior member
39 0
I am very new to active trading, mostly swing trading stocks, and it strikes me how simple successful trading systems can be (should be?) and this article pretty much comes out and says it, "trading is simple." Perhaps people get it into their head that trading must be a terribly complex endeavor because there are so few who are good at it? I am beginning to think that the reason so few are good at it is because so few can master their emotions, either because they don't do enough work and practice, or because they simply don't have it in them. I wonder if I do, but I can pretty much guarantee that if I fail it will not be for a lack of study and practice as that is the one thing I can control. In any event, is trading mechanically/physically simple and emotionally/mentally difficult?
 

Tercia

Newbie
1 0
excellent article but when do we exit,is it the reverse of the stochastic/cci
also what size stop would we use.
TERCIA
 

dannyss35

Newbie
2 0
I like the simplicity. I have read and studied for years and came to the conclusion that simple is more effective. Trading is not about getting "IT RIGHT" however a simple system that gives a 51% or greater is the way to success!
 

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