Lecture 7 - Trading Systems

Designing a system (Non-discretionary)

• Markets are dynamic

• An edge is needed (exploitable statistical advantage based on market behavior that is likely to recur in the future

• A trading system exploits a predetermined type of market activity

• A trading system has objective buy and sells

• Objectivity in a system removes emotion and enables a trader to stay focused on trading

• Must be based on sound theory so that trader can detect if the underlying hypothesis of a system has changed and thus rendered a system ineffective

Discretionary Trading System

Trading entry and exits determined subjectively by intuition and guy instinct

Disadantage of Descretionary Trading System

Gut is wrong many times - most people go broke, burn out, excitement and being right is more important than making profits

Nondiscretionary Trading Systems

Trading entry and exits determined objectively mechanically by signals (computer generated) because it is a system that runs itself based on data that is continuously fed into it

Advantage of Nondicretionary Trading Systems

Many successful traders use this, removes the emotion from trading, predetermine the decision rules, can back test results, prevents large losses and risk of ruin. Provides a mathematical edge.

Disadvantage of nondiscretionary systems

Operation is sometimes boring, requires periodic updates and adjustments…history does not repeat itself precisely. Updates and modifications may be needed

4 things to consider when trading

1. What type of strategy are you using?

2. Determine a trend filter

3. Data and market selection

4. Analyzing results

1. What type of strategy are you using

• Trend following - ex: moving average crossover system

• Counter-trend, reversion to the mean - ex: Selling overbought markets

• Swing trading = Taking short term fluctuation in direction of trend

2. Determine a trend filter

• The trend is the basis of all profits

• You must properly define your trend - regardless of your approach

• Some entry rules include a trend direction - ex: N-day breakout

A system must identify:

1. Initial stop

2. Trailing stops

3. Profit Targets

4. Opposite signals

3. Data and Market selection

• Portfolio to test on (stocks, ETF, futures)

• Time period to test (1 year, 10 years)

• Time frame to test

4. Analyzing Results

• Historical results representative of a “good” system

• Possible adjustment to the system:

  1. Abandon system completely

  2. Change in parameters for entry or exit criteria

  3. Change in tools

Short term system rules for N-day breakout

Buy 1 unit if prices exceed the highest high of the past 20 days by 1 tick

Longer term system rules for N-day breakout

Buy 1 unit if prices exceed the highest high of the past 55 days by 1 tick

Initial Stop

No trade could incur more than a 2% loss of the account value

Trailing stop

• System 1: exit prices exceed the lowest low of the past 10 days

• System 2: exit prices exceed the lowest low of the past 20 days