Corn: Watch it Grow!

Every trader seems to be looking for the perfect trading system. If you're a beginner, those promotion piece promises of huge profits with little risk sound so tempting. If you're an experienced trader, you may be frustrated with your own results and looking for something better.

But let's lay it on the line right up front: Despite the pitches you may have heard or read, there is no perfect trading system that will fit all conditions in all markets all the time for all traders. In short, there is no holy grail, no magic solutions. At the same time, to be fair, some trading systems do rather well in achieving the ideals of trading -- profitability, consistency, minimal risk. (For more insights on this type of trading, see www.TraderEducation.com)

So what makes a good trading system? Aside from the fact that a system may not fit the trader or the trader may not fit the system, this article will look at why trading systems succeed or fail and some factors to look for if you are considering a system.

What is a 'system'?

Chart patterns and technical indicators do not make a trading system. They may quite useful in market analysis and may be components of a trading system, but they cannot be a system themselves because of their subjectivity and inability to meet the criteria of a trading system.

A mechanical trading system generates precise buy/sell signals based on a specific set of rules and conditions. If certain criteria are met, certain actions are required. The system may have many parameters or only a few, but whatever the structure, subjectivity and discretion are not part of the decision-making process. Every trade is prescribed by the system's established criteria, which usually are the result of thorough research and testing to produce the best results.

In a black box system, the parameters are not revealed; in a gray box system, the parameters and logic may be known but are not changeable. If the parameters can be altered, the result may lead to the development of a trading system or strategy, but the program may be better described as an analytical tool rather than a trading system. (For more information on this topic visit www.TradingEducation.com)

Many trading systems are based on trend-following principles, which assume that a trend in place is likely to continue. Consequently, the parameters are designed to identify these trends as early as possible. Some trading systems are based on detecting market reversals, assuming a market will revert back to a central point after deviating to an extreme support or resistance point.

What systems offer

Whether you buy a trading system or develop your own, you can benefit from several positives of systems:

• Reduces the emotional element in trading. Each trade is based on a specific set of rules and not subjective interpretations of data. Emotion can be the worst enemy of any trader so anything that can reduce that aspect of trading may be quite useful for that reason alone.
• Reinforces the value of discipline. A well-tested system gives you confidence to take every trading signal required by the system's rules, even when it may not seem sensible. You do not cherry-pick to select only the trades you "like" and don't have to be concerned about what the experts and talking heads are saying.
• Gives you a chance to back-test the parameters and rules over an extensive database to get an idea how it might perform in the future before you put your money on the line -- assuming, of course, that the back-testing is done properly and is not just optimized curve-fitting. Optimizing is okay to discover the best criteria for entry, exit, stop placement, etc., but don't let your quest to get the best numbers mislead you into thinking your system will do something it can't do in real trading.

Potential system faults

Everyone is probably aware of the warnings about hypothetical track records and the risks of trading. Remember the regulators' words, "Past performance is no guarantee of future success . . . " This is not to excuse a poorly designed system, but the fault for trading systems that don't perform as expected may often have more to do with the trader than the system. Here are some things you should check before you jump into any trading system:

System logic. The vendor probably won't tell you the exact parameters of a proprietary trading system, but you should know enough to be comfortable with the system's approach to trading. Of course, if a system is making money hand over fist, you may not care about the precise details, but when times get tough, having an idea about what is happening can be critical for building confidence in a system. Without confidence, you aren't likely to stick with the system.

Performance report evaluation. No matter how well it is done, back-testing may not accurately reflect real-world trading results. For example, back-testing may not be able to detect whether a high or low of a price bar occurred first or whether a trade signal was actually able to be executed at the price indicated or whether you might have been stopped out before a big profit or loss took place. Performance reports are useful for comparing systems, but don't be surprised if a system doesn't produce exactly the same results as the report suggests.

Track record timing. Is the track record based on a period that was particularly favorable for the system's approach? For example, a track record compiled during a bull market may not hold up in all types of market conditions, especially with current conditions. Check the track record dates carefully.

Best trade, worst trade. A system that reported profits of $10,000 may have made $8,000 of that gain on a single trade. What if you had missed that one trade? Your performance might be far different from the system's performance. Check out those days when a big market move might have made a big difference in a system's performance.

Number of trades. Track records frequently say, "Not including commissions and fees," or may not allow for any slippage. If it takes a lot of trades to generate the profits indicated, the costs of trading and slippage may eat up profits in actual trading.

Percent of winning trades. You can have a profitable system with more losing trades than winning trades. But the key issue is: Can you retain confidence to stay with a system that has more losers than winners?

Profit per trade. If a system trades frequently and the average profit per trade is relatively low, commissions and a few bad fills can eat into profits quickly. Such a system may not be a worthwhile pursuit.

Maximum drawdown. The first number traders usually want to know about a system is net profit. After all, if a system isn't profitable, there's no reason to trade it. But a number that is almost as important is the drawdown figure. Almost any trading system, even the most promising ones, will have losing periods along the way. What is your tolerance for loss? Would you rather gain 100% with a maximum drawdown of 60%, or would you be more comfortable settling for a 50% gain with a maximum drawdown of 10%? Even when you know the possibilities for the big setback exist, the pain threshold can be the deciding factor in evaluating a system. (For more information on this topic visit www.TradingEducation.com)

Capitalization. One of the main reasons traders lose is inadequate capital to trade a system as intended. A trader may pay $3,000 for a black-box system guaranteed to produce profits if traded exactly as designed and then have only $30,000 to trade a system that requires $50,000 to make all the recommended trades. The first five trades in a row are losers, cutting your capital in half. Then you pick your trades, which invariably turn out to be losers while the unselected trades become the big winners that produce the profits the system vendor hypes. Who is at fault, you or the system? Not only do you lose money on the system trades but you also can't collect on the guarantee because you didn't trade all the system's recommendations as required. (Of course, once you give up on the system, it has a streak of winners.)

Over-trading. The other side of the funding coin is having so much confidence in a trading system that you take every signal with larger positions that you should. If a system is so good, why not trade larger size and make more money faster? The system may work 9 times out of 10, but the one time it doesn't may lead to disaster and the loss of your trading stake, the worst thing that can happen to a trader.

Automated or self-directed? Will you trade the system yourself or will a broker trade the system for you automatically? You may not have the time to trade a system as designed, but can you trust someone else to handle your trading?

Taking the analysis route

A system approach to trading does have much to offer, but relying too heavily on a trading system can be like putting all of your eggs in one basket. First, you have to try to find that perfect system, then the system has to perform as advertised. Instead, many traders would be better served by using an analytical tool like VantagePoint Intermarket Analysis Software (www.TraderTech.com).

If you cannot view a screenshot of the
VantagePoint Intermarket Analysis Software, go here.
Courtesy of VantagePoint Trading Software

VantagePoint is not a trading system but a tool that uses intermarket analysis to produce predictive indicators that project short-term trend direction before traditional indicators do. Combined with traditional chart analysis and fundamental analysis in a Synergistic Market Analysis approach, VantagePoint  can give traders more flexibility in making and taking trading decisions and can help traders get into and out of positions with larger profits and/or smaller losses than might be possible by sticking with a system's parameters.