What are the significant factors that need to be considered when looking to create a trading system. In this article we look at how to start creating your own system.
Its long been understood by most and proven by experience that trading is a hard trade to ply, and those who decide to tread on this path have to take their bearings on a variegated sea of information, diverse and, oftentimes, controversial. A tyro trader is flabbergasted by the panoply of approaches, trading means, and celebrated personalities as soon as he opens his first trading magazine. Poised for choice, he kicks off browsing Internet forums, turns for dubious advice to his slightly more versed acquaintances or joins one of the guru-lead sects that dispense prefabricated, moderately-priced trading wisdom to whoever joins for a fee, never actually taking into account the vital factors upon which the success of any trader hinges.
Most of the time, the above fast-food approach to any serious business is fraught with failure and most anyone taking it to trading is bound to fail. Why? Because the very nature of trading as a business runs counter to what most losing traders seek to easily find and what their lionized teachers want them to believe and pay for: there is no standardized solution to becoming a successful trader available for sale. Just because trading profitably is critically dependent on one's personality.
There are millions of people around us and most of them never come across their twins once in their life-spans. And even if some do wear the same clothes, their food tastes and music preferences will most probably be different. Can anyone issue all of them with a set of possessions that will equally befit everyone? As far as trading is concerned, the - shoes?, "ties," and that most cherished "album" you've been listening to half your life now have to be selected as, if not more, carefully.
A trading system that is a perfect fit for one trader may easily become the undoing of another. Someone in possession of enough capital can take the amount of related risk that is capable of destroying someone with more modest financial means. Someone trading full-time can see more of the market and be in a better position to profit than his colleagues who take up trading alongside another career. Someone who has a large amount of experience can outgun beginner traders at a specific technique and should probably rely on this one more than those who are just trying to get a handle on this approach. The number of the vital influencing factors is very large. Which of them matter the most?
Undoubtedly, the two crucial influencing factors that need to be addressed and solved by any trader first turn are risk tolerance and time.
Risk tolerance as a trader's professional trait, providing the basis for a critically important part of his trading system, emanates from his psychological profile. To measure the most fitful risk tolerance level, the trader simply needs to look more closely at his lifestyle, habits, and psychological peculiarities to answer the following questions: Can I be a trader? Do I have enough patience to calmly follow a trend and for how long can I be following it? How much am I willing to lose? What is the maximum profit that will not destroy trading system, perilously exposing me to excessive risks? When all of these questions are honestly and adequately answered, the results need to be considered and analyzed. And it is only when the trader sees what can and what cannot be done by him that he should get down to composing his own trading system. Many a successful trader cannot boast about the completion of this task after years of trading, so make sure that you have answered and analyzed the main questions prior to trying your newly created system on practice.
However, is it really necessary to spend time and effort on what sometimes looks like getting disposed of a goofy test from school? Yes, it is, for this time is valuably invested. Those who select to use somebody else's systems most often lack the essential discipline to follow those let alone they lack the understanding of what and why they are actually doing. Often, the desire to improve an acquired system leads to this system's destruction. As shown by experience, most of traders relying on purchased or borrowed systems cannot possibly meet the conditions, stipulated by them, due to psychological reasons. Sometimes, it seems that somebody else's system cannot be used gainfully at all, and any trader striving for success must have his own one, created and tested by him and no one else.
Creating One's Own System - a Straight Way for a Beginner
For a start, he should get a hold of a TA book and read the descriptions of all the indicators and formulas.
Then, he should take some good software, get the indicator that has taken his fancy into Strategy Builder, and make sure that using this indicator alone is unprofitable. After this it best to ask Strategy Builder to point to the spots where buys and sells have occurred. Simulation Manager will display the equity, performance report, and the rest of the required information. The next step is to look at the screen and see where and why your favorite indicator didn't work. The same procedure should be performed for all the indicators you've read about. Next, you select an indicator that seems to suit you best from those that have been tested (naturally, its performance does contain some errors too) and start selecting another indicator to correct at least some of the errors made by the first indicator (an illustrative example of such a tandem is Moving Average - stochastic). The resulting system should be loaded into the Simulation Manager and the procedure you performed the first time should be launched over again to see what and where has gone wrong. This cycle should be repeated until the addition of new indicators starts decreasing the number of the errors.
However, at a certain point the addition of another indicator will tell negatively on the system's performance.
Here two options are possible: 1) You settle for the derived system; 2) You dump the system and start afresh. Please note that even if you select to ditch the created system your time hasn't been wasted for you gain the experience of creating trading systems, analyzing reports and learning about the advantages and disadvantages of the indicators you have tested. And another thing - try not to simply incorporate the standard use of an indicator into a system but rather discover those of its properties that aren't described in the book because the author isn't aware of them or because these properties don't fit into the authors concept of system creation (you are creating a system of your own, not copycatting, aren't you?). After 3-12 months of strenuous work, you will receive a proprietary system, a rather simple one, to speak the truth.
Naturally, the above way of creating a proprietary trading system has its own pros and cons, but, by all means, it is the best one for rookies. To complete the full cycle, the system the trader settles for should be compared with the benchmark systems, from the more simple ones, such MA Crossover (and if your system is worse, you should probably mull over why you thought your system was good) to the systems, developed by professionals, such as the Wild-ranging days system described by Jack Schwagger in his well-known book Technical Analysis or Chuck LeBeau's Volatility/Chandelier benchmark . If the results you received are better, you can start real-time trading. If not, you should keep on improving your system.
Principle vs. Results
When a trader doesn't endeavor to fathom the "mystical force" governing the market and his system is simply following the trend along with the price, his life becomes a lot easier and the profit he makes is greater than that made as a result of metaphysical research. There is a simple rule by following which one can dispose of the temptation to react to all the market moves by using sophisticated modern mathematical methods. This rule is "Trade your money, not the market". Read up in detail on the trading strategies of the world's best traders. There are a large number of different approaches used by them that look totally primitive from the point of view of mathematics. It seems many of these successful traders bluff, but it's not so. After all, can you name at least one really successful trader with a good compound return for the last 10 years, who trades using complex methods?
Simplicity and Complexity
With interest and amazement one can often see articles in the press and discussions between the adherents of the various mathematical approaches that attempt to answer the humanity's basic question: "How to buy for less and sell for more?" Basically, the attempts to solve the problem by finding mathematical interdependencies in the market behavior are rather commendable. However, it is quite difficult to agree with this approach as it seems both too complicated and too superficial to be efficient on practice. The approach seems inefficient to me because the very task that needs to be solved is not formulated clearly; hence, the desired result cannot be achieved. If the task consists in describing the behavior of the market through the creation of its mathematical model, one can hardly hope for success considering that this multi-dimensional process uses just a few integers but an infinitely large number of variables. Rather, the model will be bulky, with significant inaccuracies, and, just like any other complex system, with a high probability of performance failure.
If you add to this the one-sidedness of a solely mathematical approach and overlook the involvement of other sciences, such as psychology, economy, sociology, financial analysis and even meteorology, your system will be an unviable creation, having to do nothing with the reality. But if you do bring the rest of the sciences into play, the result will be an unfathomable mess.
If the task is formulated otherwise, for example, as receiving a positive trading result over a more or less prolonged period of time, what does all that lofty mathematical gobbledygook have to do with that? In this case, the task is solved on the level of common sense and elementary knowledge of algebra and geometry. The market's natural characteristics, such as its ability to move in two directions only, the existence of tendencies and minimum amplitude of movement within a period of time are known to everyone and provide enough initial data for building a practically applicable and efficient methodology of profiting from market fluctuations. Moreover, this can be done even without any preliminary forecasting or complex mathematical calculations by the mere creation of a system of signals for entering and exiting the market. This system will be efficient only if the probability of a positive result of each signal is higher than that of a negative one. There is no need for bulky trading systems with their volume of information impossible to be processed by the human brain, nor is there any need for powerful computer equipment, as the whole of the system can be controlled by the trader. A strategy must be responsible for simpler questions. Even if you use an advanced mathematical technical analysis method such as neural networks, the tasks you set should be simple. For example, when neural networks are applied, the diverse multitude of the factors responsible for the future prices, it is a lot more efficient to assess the current situation and the impact it may have on the future developments than make attempts to determine precisely the price that will settle in a few days. Instead of forecasting future prices directly, you can use your network to find out whether the current trend will continue or whether the direction of the price is likely to change.
Looking for the Significant Factors
As far as the "weight and significance" of the decision-making factors or, in other words, trading indicators are concerned, the problem is so complicated that no mathematical methodology/expert system/genetic algorithm/neural network can solve the task properly. If, for example, a certain set of indicators is created and a neural network is instructed to "weigh" their significance, the network will keep on doing so even when the indicator doesn't need to be considered at all due to the current market conditions. Formulating the conditions for the indicator's temporary "suspension" from the market is, in turn, extremely difficult. Experiments have proven that the indicators "look" in the same direction very seldom - up to about 75% of them several times per year - the rest of the time one has to painfully choose between two dozen of indicators based on their "significance". In this respect, if we do want to use neural networks we should have a set of rules that will define whether or not the neural network output is of any use in the current market situation. It is true that neural nets can detect subtle, non-linear interdependencies and complex patterns no other methods of technical analysis are able to uncover. However, one should bear it in mind that a neural network (or any other AI technique) can cover one of the simple market aspects, and should be used as part of a committee of models and rules or be supervised by the trader who will decide (just like with the indicators) whether or not to take the information provided by the nets into account and which of the networks are more significant in the current situation than others.
Universal System
Sooner or later the market starts defending itself against any system by changing its characteristics and the system can become inefficient. The ideal system is a "Holy Grail", a dream that is not destined to come true for this dream coming true would destroy the very idea of the market which would be bought up by the owner (or owners) of the ideal and efficient system, always bringing good results but sooner or later becoming known to everyone and, thus, mortal.
In my opinion, one shouldn't regard the market as something driven by a horde of losers and affording those who are smart enough opportunities for profiting from human weaknesses (it's not a secret that any market profit is somebody else's loss). Rather, from the philosophical point of view, any market seems to be none other than a natural niche in which the fittest one survives.
Its long been understood by most and proven by experience that trading is a hard trade to ply, and those who decide to tread on this path have to take their bearings on a variegated sea of information, diverse and, oftentimes, controversial. A tyro trader is flabbergasted by the panoply of approaches, trading means, and celebrated personalities as soon as he opens his first trading magazine. Poised for choice, he kicks off browsing Internet forums, turns for dubious advice to his slightly more versed acquaintances or joins one of the guru-lead sects that dispense prefabricated, moderately-priced trading wisdom to whoever joins for a fee, never actually taking into account the vital factors upon which the success of any trader hinges.
Most of the time, the above fast-food approach to any serious business is fraught with failure and most anyone taking it to trading is bound to fail. Why? Because the very nature of trading as a business runs counter to what most losing traders seek to easily find and what their lionized teachers want them to believe and pay for: there is no standardized solution to becoming a successful trader available for sale. Just because trading profitably is critically dependent on one's personality.
There are millions of people around us and most of them never come across their twins once in their life-spans. And even if some do wear the same clothes, their food tastes and music preferences will most probably be different. Can anyone issue all of them with a set of possessions that will equally befit everyone? As far as trading is concerned, the - shoes?, "ties," and that most cherished "album" you've been listening to half your life now have to be selected as, if not more, carefully.
A trading system that is a perfect fit for one trader may easily become the undoing of another. Someone in possession of enough capital can take the amount of related risk that is capable of destroying someone with more modest financial means. Someone trading full-time can see more of the market and be in a better position to profit than his colleagues who take up trading alongside another career. Someone who has a large amount of experience can outgun beginner traders at a specific technique and should probably rely on this one more than those who are just trying to get a handle on this approach. The number of the vital influencing factors is very large. Which of them matter the most?
Undoubtedly, the two crucial influencing factors that need to be addressed and solved by any trader first turn are risk tolerance and time.
Risk tolerance as a trader's professional trait, providing the basis for a critically important part of his trading system, emanates from his psychological profile. To measure the most fitful risk tolerance level, the trader simply needs to look more closely at his lifestyle, habits, and psychological peculiarities to answer the following questions: Can I be a trader? Do I have enough patience to calmly follow a trend and for how long can I be following it? How much am I willing to lose? What is the maximum profit that will not destroy trading system, perilously exposing me to excessive risks? When all of these questions are honestly and adequately answered, the results need to be considered and analyzed. And it is only when the trader sees what can and what cannot be done by him that he should get down to composing his own trading system. Many a successful trader cannot boast about the completion of this task after years of trading, so make sure that you have answered and analyzed the main questions prior to trying your newly created system on practice.
However, is it really necessary to spend time and effort on what sometimes looks like getting disposed of a goofy test from school? Yes, it is, for this time is valuably invested. Those who select to use somebody else's systems most often lack the essential discipline to follow those let alone they lack the understanding of what and why they are actually doing. Often, the desire to improve an acquired system leads to this system's destruction. As shown by experience, most of traders relying on purchased or borrowed systems cannot possibly meet the conditions, stipulated by them, due to psychological reasons. Sometimes, it seems that somebody else's system cannot be used gainfully at all, and any trader striving for success must have his own one, created and tested by him and no one else.
Creating One's Own System - a Straight Way for a Beginner
For a start, he should get a hold of a TA book and read the descriptions of all the indicators and formulas.
Then, he should take some good software, get the indicator that has taken his fancy into Strategy Builder, and make sure that using this indicator alone is unprofitable. After this it best to ask Strategy Builder to point to the spots where buys and sells have occurred. Simulation Manager will display the equity, performance report, and the rest of the required information. The next step is to look at the screen and see where and why your favorite indicator didn't work. The same procedure should be performed for all the indicators you've read about. Next, you select an indicator that seems to suit you best from those that have been tested (naturally, its performance does contain some errors too) and start selecting another indicator to correct at least some of the errors made by the first indicator (an illustrative example of such a tandem is Moving Average - stochastic). The resulting system should be loaded into the Simulation Manager and the procedure you performed the first time should be launched over again to see what and where has gone wrong. This cycle should be repeated until the addition of new indicators starts decreasing the number of the errors.
However, at a certain point the addition of another indicator will tell negatively on the system's performance.
Here two options are possible: 1) You settle for the derived system; 2) You dump the system and start afresh. Please note that even if you select to ditch the created system your time hasn't been wasted for you gain the experience of creating trading systems, analyzing reports and learning about the advantages and disadvantages of the indicators you have tested. And another thing - try not to simply incorporate the standard use of an indicator into a system but rather discover those of its properties that aren't described in the book because the author isn't aware of them or because these properties don't fit into the authors concept of system creation (you are creating a system of your own, not copycatting, aren't you?). After 3-12 months of strenuous work, you will receive a proprietary system, a rather simple one, to speak the truth.
Naturally, the above way of creating a proprietary trading system has its own pros and cons, but, by all means, it is the best one for rookies. To complete the full cycle, the system the trader settles for should be compared with the benchmark systems, from the more simple ones, such MA Crossover (and if your system is worse, you should probably mull over why you thought your system was good) to the systems, developed by professionals, such as the Wild-ranging days system described by Jack Schwagger in his well-known book Technical Analysis or Chuck LeBeau's Volatility/Chandelier benchmark . If the results you received are better, you can start real-time trading. If not, you should keep on improving your system.
Principle vs. Results
When a trader doesn't endeavor to fathom the "mystical force" governing the market and his system is simply following the trend along with the price, his life becomes a lot easier and the profit he makes is greater than that made as a result of metaphysical research. There is a simple rule by following which one can dispose of the temptation to react to all the market moves by using sophisticated modern mathematical methods. This rule is "Trade your money, not the market". Read up in detail on the trading strategies of the world's best traders. There are a large number of different approaches used by them that look totally primitive from the point of view of mathematics. It seems many of these successful traders bluff, but it's not so. After all, can you name at least one really successful trader with a good compound return for the last 10 years, who trades using complex methods?
Simplicity and Complexity
With interest and amazement one can often see articles in the press and discussions between the adherents of the various mathematical approaches that attempt to answer the humanity's basic question: "How to buy for less and sell for more?" Basically, the attempts to solve the problem by finding mathematical interdependencies in the market behavior are rather commendable. However, it is quite difficult to agree with this approach as it seems both too complicated and too superficial to be efficient on practice. The approach seems inefficient to me because the very task that needs to be solved is not formulated clearly; hence, the desired result cannot be achieved. If the task consists in describing the behavior of the market through the creation of its mathematical model, one can hardly hope for success considering that this multi-dimensional process uses just a few integers but an infinitely large number of variables. Rather, the model will be bulky, with significant inaccuracies, and, just like any other complex system, with a high probability of performance failure.
If you add to this the one-sidedness of a solely mathematical approach and overlook the involvement of other sciences, such as psychology, economy, sociology, financial analysis and even meteorology, your system will be an unviable creation, having to do nothing with the reality. But if you do bring the rest of the sciences into play, the result will be an unfathomable mess.
If the task is formulated otherwise, for example, as receiving a positive trading result over a more or less prolonged period of time, what does all that lofty mathematical gobbledygook have to do with that? In this case, the task is solved on the level of common sense and elementary knowledge of algebra and geometry. The market's natural characteristics, such as its ability to move in two directions only, the existence of tendencies and minimum amplitude of movement within a period of time are known to everyone and provide enough initial data for building a practically applicable and efficient methodology of profiting from market fluctuations. Moreover, this can be done even without any preliminary forecasting or complex mathematical calculations by the mere creation of a system of signals for entering and exiting the market. This system will be efficient only if the probability of a positive result of each signal is higher than that of a negative one. There is no need for bulky trading systems with their volume of information impossible to be processed by the human brain, nor is there any need for powerful computer equipment, as the whole of the system can be controlled by the trader. A strategy must be responsible for simpler questions. Even if you use an advanced mathematical technical analysis method such as neural networks, the tasks you set should be simple. For example, when neural networks are applied, the diverse multitude of the factors responsible for the future prices, it is a lot more efficient to assess the current situation and the impact it may have on the future developments than make attempts to determine precisely the price that will settle in a few days. Instead of forecasting future prices directly, you can use your network to find out whether the current trend will continue or whether the direction of the price is likely to change.
Looking for the Significant Factors
As far as the "weight and significance" of the decision-making factors or, in other words, trading indicators are concerned, the problem is so complicated that no mathematical methodology/expert system/genetic algorithm/neural network can solve the task properly. If, for example, a certain set of indicators is created and a neural network is instructed to "weigh" their significance, the network will keep on doing so even when the indicator doesn't need to be considered at all due to the current market conditions. Formulating the conditions for the indicator's temporary "suspension" from the market is, in turn, extremely difficult. Experiments have proven that the indicators "look" in the same direction very seldom - up to about 75% of them several times per year - the rest of the time one has to painfully choose between two dozen of indicators based on their "significance". In this respect, if we do want to use neural networks we should have a set of rules that will define whether or not the neural network output is of any use in the current market situation. It is true that neural nets can detect subtle, non-linear interdependencies and complex patterns no other methods of technical analysis are able to uncover. However, one should bear it in mind that a neural network (or any other AI technique) can cover one of the simple market aspects, and should be used as part of a committee of models and rules or be supervised by the trader who will decide (just like with the indicators) whether or not to take the information provided by the nets into account and which of the networks are more significant in the current situation than others.
Universal System
Sooner or later the market starts defending itself against any system by changing its characteristics and the system can become inefficient. The ideal system is a "Holy Grail", a dream that is not destined to come true for this dream coming true would destroy the very idea of the market which would be bought up by the owner (or owners) of the ideal and efficient system, always bringing good results but sooner or later becoming known to everyone and, thus, mortal.
In my opinion, one shouldn't regard the market as something driven by a horde of losers and affording those who are smart enough opportunities for profiting from human weaknesses (it's not a secret that any market profit is somebody else's loss). Rather, from the philosophical point of view, any market seems to be none other than a natural niche in which the fittest one survives.
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