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A Primer on
Technical Analysis
IV. Technical Trading Systems
What is a Trading System?
A trading system is a set of rules
that defines conditions required to initiate and exit a trade. Usually,
most trading systems have many parts, such as entry, exit, risk control,
and money management rules. The rules of a trading system can be
implicit or explicit, simple or complex. A system can be as simple as
"buy sweaters in summer", or "buy when she sells".
By definition, the system must be feasible. Ideally, the system accounts
for "all" trading issues, from signal generation, to order
placement, to risk control. A good way to visualize effective system
design is to stipulate that someone who is not a trader must be able to
implement the system. In practice, every trader uses a system. For most
traders, a system could really be many systems. It could be
discretionary, partly discretionary, or fully mechanical. The systems
could use different types of data, such as 5-minute bars or weekly data.
The systems may be neither consistent nor easy to test; the rules could
have many exceptions. A system could have many variables and parameters
on the same market. You can trade different parameter sets on different
markets. You can even trade the same parameter set on all markets. It
should be clear by now that there is no single universal trading system.
Every trader adapts a "system" to his or her style of trading.
However, it is possible to draw a distinction between a discretionary
trader and a 100% mechanical system trader.
Why should you use a Trading
System?
The most important reason to use a
trading system is to gain a "statistical edge". This
often-used term simply means that you have tested the system, and the
profit of the average trade - including all losing and winning trades -
is a positive number. This average trade profit is large enough to make
this system worth trading - it covers trading costs, slippage, and is,
on average, likely to perform better than competing systems.
Another reason to use a trading
system is to gain objectivity. If you are steadfastly objective, you can
resist the siren call of news events, hot tips, gossip, or boredom.
Suppose you are a chart trader and you enjoy some flexibility in
interpreting a given chart formation. It is very easy to identify a
pattern after the fact, but it is rather difficult to do so as the
pattern evolves in real time. Hence, analysis can paralyze you, and you
may never make an executable trading decision. Being objective frees you
to follow the dictates of your analysis.
Consistency is another vital reason
to use a trading system. Since the few rules in a trading system are
applied in precisely the same way each time, you are assured of a rare
consistency in your trading. In many ways, objectivity and consistency
go together. Although consistency is known as the hobgoblin of little
minds, it is certainly a useful trait when you are not quite a champion
trader.
Robust Trading Systems
A robust trading system is one that
can withstand a variety of market conditions across many markets and
time frames. A robust system is not overly sensitive to the actual
values of the parameters it uses. It is not likely to be the worst or
best performer, when traded over a "long" time (perhaps 2
years or more). Such a system is usually a trend-following system, which
cuts losses immediately and let profits run. The key feature to note is
that, when systematically implemented over a "long" time and
over many markets, robust systems tend to be, on the whole, profitable.
If executed correctly, they guarantee entry in the direction of the
intermediate trend, cut off losses quickly, and let profits run.
Countless variations of these systems exist, and trend-following systems
seem to account for a large percentage of professionally managed
accounts. Robust systems do not make many assumptions about market
behavior, have relatively few variables or parameters, and do not change
their parameters in response to market action. There is no sharp drop in
performance due to small changes in the values of system variables. Such
systems are worthy of consideration in most portfolios, and are
reasonably reliable. In addition, they are easy to implement.
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