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When it comes to trading systems, there are three distinct camps. One
subscribes to the belief that the more investors who follow a system, the more
likely it is to be successful. Another faction is convinced that the only route
to investment riches is to keep a trading strategy a well-protected secret.
Still another group of investors begins trading without any system at all.
What's common to all of these investors is that many of them will encounter
failure. When they do, they are faced with a decision: to continue searching
for the right trading system, or to abandon the effort entirely. It's no small
decision - choosing the right path can quite literally make or break your
fortune. Read on to learn how to assess a system and determine its worth.
Tried and Tested Trading Systems
Many investors do not feel confident about designing a trading system that will
successfully squeeze profit out of an unpredictable market. Often, people look
for a system that is "tried and tested", in the belief that a system that has
proved profitable for others will be profitable for them too. This can be the
case, and sometimes a very popular system can generate its own momentum and
produce profit for its devotees. However, investors must be aware that not all
systems are successful in all market conditions, making "tried an tested" an
unreliable measure of a trading system's value. (For more, see Trading Systems:
Introduction.)
Many systems can only be profitable under the market conditions for which they
were designed; in fact, most are designed to be used in either a ranging market
or a trending market. In light of this, some active traders use two different
systems, depending on the prevailing market.
System Vs. Method
A prevalent view is that the vast majority of traders cannot or choose not to
follow a system properly. Therefore, this view suggests that it really doesn't
matter how many traders know about a particular system or attempt to follow it.
Famously successful trader Richard Dennis, in his "turtle" experiment, took a
group of people (turtles) who had never traded before and taught them his
system. The results were compelling: although the turtles became skilled
traders and made many millions, the success of the group varied dramatically.
Eventually, the system was made public, free of charge, with the reasoning that
even with what turned out to be rather simple system rules, most traders who
tried could not or would not adhere to the system. This experiment illustrates
that faithful implementation of a system may be more important than system
selection; therefore, investors must be realistic and choose one they are
willing to rigidly follow. (For related reading, see Master Your Trading
Mindtraps.)
The Lemming Effect
An equally somber analysis that draws a different conclusion suggests that an
investor should not follow any system that is publicly available specifically
because other traders fail to follow the same system correctly. The reasoning
behind this notion is that the lack of complete adherence to the rules and the
novice nature of public system traders causes them to make bad trading
decisions - such as entering a trade too late and exiting too early. This, they
believe, reduces the profit potential for those who do trade exactly as the
system demands, as the early exiting causes the price to stall or even reverse
direction.
There is a persistent belief that the more widely publicized and used a system
is, the less likely it is to be profitable. It is fair to say that this effect
is unlikely unless the system is highly popular or there is very little
liquidity in the market. Logic also dictates that if this lemming effect did
happen, the more followers the system had the greater the effect would be.
Therefore, an investor looking to follow a system should "paper trade" the
system in a demo account for some time, exactly according to the trade rules,
keeping an eye out for signs of early exiting. The best indicator of this is to
test trades that consistently collapse before reaching their potential. It
would be unwise to attempt to time the exit from these trades before the
collapse because, traditionally, collapses come sooner and sooner until the
trade has insufficient profit to justify making it at all. This is because the
other proponents all try to beat the collapse themselves. Just as with the
manufacturing of physical products, competition drives down profit margins to
the lowest acceptable point. (For related reading, see How Investors Often
Cause The Market's Problems.)
Alpha Dog
In the world of physical products, the market rewards the best quality, best
price, best value and most efficient. In the investment and financial trading
world, the measure of that market reward is called alpha. This is often used as
an indicator of a trader of investment manager's skill; alpha attempts to
measure investing success over and above the returns generated by the market on
its own. To beat the market, an investor has to be better than the average
trader. In other words, he or she needs to extract alpha from the market. (For
more insight, read Adding Alpha Without Adding Risk.)
There is a growing belief that alpha is finite; David S. Hsieh, a professor of
finance at the Fuqua School of Business at Duke University, in a speech at the
CFA Institute's hedge fund conference in 2006, reckoned the amount of alpha in
the hedge fund industry was $30 billion. However, if Alpha is finite, this
would suggest that anyone who is successfully extracting it from the market
would be unable to make their system public and continue turning a profit. As
such, prudent investors should always view any system with a healthy amount of
skepticism, particularly those that are for sale.
Thin the Herd
Investors profit from the disparity between a stock's inherent value and the
market's perceived value or market price. If an investor is convinced that a
stock pick has greater value than the market has currently placed on it, he or
she can gain big when the market realizes its mistake and moves to correct the
price.
The trade window, or time to buy, an undervalued stock is naturally limited by
the market correction. However, this disparity's lifespan is limited and, as a
consequence, so is profit potential. If the goal of most trading systems is to
identify either the disparity itself or the market's move to correct it, then
it is logical to assume that a popular trading system - with many devotees
chasing the same instance of disparity - would result in diluted profits.
Traders who subscribe to this belief give no credence to any system used by
anyone else. A system made public, they reason, could not have been very good;
after all, why would a trader release a profitable system when it would
certainly diminish their own success? These investors believe that successful
traders must develop their own unique systems and never make them public.
Designing a proprietary system gives the trader flexibility to tweak it and
adapt it to the various market conditions. It may seem a daunting task, but to
design a trading system is easier than one would think. Keep it simple and
start with the basics, followed up with repeated testing and fine-tuning. (To
learn more about how to do this, read Basics Of Trading Systems and Trading
Systems Coding.)
Conclusion
If in any doubt as to which approach to take, logic suggests erring on the side
of caution. Why risk a public system if you can design your own? Creating a
trading system from the ground up gives the trader the skills and confidence
required to deal with changing market conditions. However, if an investor
decides to use an existing, publicly available trading system, he or she should
not only backtest, but forward-test too. Regardless of what you choose, deploy
the system in a live-test environment before risking any investment capital,
and keep your eyes open for signs of an over-used strategy.
by Ian Huntsley