4 Simple Ways to Determine if Your Trading System is Truly Viable

Boris Schlossberg

One of the best trading resources that I recently discovered is Andrew Swanscott’s podcast called Better System Trader. Even if you are not interested in systematic research and just want to trade discretionarily, the trading insights from the interviews are worth a listen.

One episode I found very valuable is an interview with Art Collins who is long time systematic trader in US stock and bond futures. Art wrote a book, called Beating the Financial Futures Markets which I have yet to read, but his analysis of what makes for a viable trading system really impressed me so I thought this week I would share his ideas with you.

Before all else, Art makes a point that I’ve heard over and over again from many different traders. The single most important aspect of the system is that it be in sync with your personality. If you are like me and like constant action then trading 100 times per day on a 1-minute chart is perfectly fine, as long as you adjust the system to the reality you’ve chosen. If you are like Kathy and think that such an approach is utterly ridiculous and prefer to make 2-3 well-chosen trades per day using the four-hour chart -- that fine too. (I would rather get a root canal without anesthesia, but to each is own.)

That being said, Art has four key metrics to judge a system.

One.
Does it make sense? Do you understand the underlying drivers? If you do not understand what the system is doing you will abandon it at the first sign of trouble. Generally, as I’ve noted many times before there are only two types of trading systems -- continuity and mean reversion. Systems will naturally underperform in adverse market regimes, but If you have a favorable market environment (trending) and your continuity system is not performing you need to quickly assess what’s wrong and to do that you need to know how the trades work.

Two.
Don’t Optimize. Don’t Tweak. Don’t try to avoid the pain. Accept the drawdown because if you don’t it will only get worse. So if you are looking at a series of parameters make sure that if you chose a slightly different one the results will not be much different from all the other parameters. If they are that means your parameter is less than worthless because it only works on a particular set of data in the past.

Three.
At very minimum, the system must work on related markets. For Art that means that if the system is designed for S&P it must also work on Nasdaq and Russell. For us, in FX we need to make sure that the trade idea works on several related pairs, not just one. Earlier this week I had a system that looked very promising but when I analyzed the underlying data I realized that GBPUSD was responsible for 62% of the profit but it comprised just 16% of the trades. My new version was much better balanced with no pair accounting for more than 25% of the profit while comprising 16% of the portfolio. That’s the kind of distribution you want because that means you are capturing repeatable price behavior rather than one-off action.

Four.
And this is perhaps the most important and overlooked aspect of system analysis. Make sure that the bulk of your profits does not come from a very narrow time interval because then it’s a function of luck rather than skill. Since I day trade around the clock with fixed stops and losses, I avoid that problem by creating as much uniformity in my trades as possible. But if you trade on longer time frames with variable profits and losses you should study your results very carefully to make sure that they are not skewed by one or two lucky big trades.

Lastly, Art says that one of the best ways to analyze the robustness of a system is to divide the total profit by maximum drawdown -- something I’ve intuitively done for years and prefer much more than the traditional Sharpe or Sortino ratio measures. But even here you need to be careful. If your system has massively large stops it could provide you with a very unrealistic picture of its robustness. For example one of the best traders in my room had a “return on account” (that’s what this ratio is called) of more than 10. She was up 22% on equity with a drawdown of only 2%. But that’s because the system was trading with massive negative skew (the risk-reward was 1:5) so the losses were rare and provided a false sense of security. Fortunately, she wasn’t fooled by the data and traded at very low leverage to prepare for any large losses that could come like an avalanche. Generally, the return on account of 2:1 or better is a sign that you are doing things well and a much better way to assess the risk of the strategy than the simple risk/reward ratio of any given trade.

I’ll be in Madrid next week at the annual Forex Day show, so no column next week, but come say hi if you are there, it would be great to meet everyone at the show.

Simple, Not Easy

Boris Schlossberg

Markets are simple, not easy. There are really only two trades -- continuity or mean reversion. Ultimately, all of your financial success depends much more on market regime rather than any specific strategy. That’s why guys like Richard Dennis could take $400 to $200 million in the early 1970s and 1980 ’s and then puke it all back in the late 1980’s and early 1990’s.

I still remember as a young pup at Drexel Burnham being told to sell the s-t of out Dennis’s fund because the guy was “genius”. He, of course, managed to blow up every single dollar of the $80 million Drexel raised for him, some of it on remarkably stupid plays like selling out of the money puts on the last day of expiry -- a move that is more a hallmark of dentist trading his TD Ameritrade account, then the “Prince of the Pits”. By the 1990’s he had blown up his second trading fund and was never heard from again.

Dennis of course, like so many of the “genius” turtles, was a very fortunate beneficiary of a very unique market regime. Late 1970’s and 1980’s saw price persistence in commodities that was never to be seen again. Trends worked because prices went only one way for a very long time. Once the regime changed to mean reversion with its bewildering twists and turns, trend trading lost all of its luster. Suffice it to say that if turtle traders showed up 15 years late to the game you would never hear or know about any of them. That’s why all of their strategies are less than useless now, generating nothing but losses and commissions. The few rare wins never cover the multitude of losses created by fake breakouts.

Market regime can make the stupidest people look brilliant and the smartest people look like idiots. Right now your uncle Morty, who has been investing all his 401-K money in SPY, is ready to light a fat Cuban with a hundred dollar bill and celebrate the fact that he has beaten every hedge fund in the world by 1000 basis points every year for the past decade running.

Everywhere you look, the advice from every financial advisor is to just buy the index and you will be rich by retirement. I may not know much, but after 35 years on Wall Street, I do know one thing. If everyone is telling you to do something, it has to be the single worst advice you can take. The market has been in an uninterrupted rally for 10 years. Buying the index is simply believing that this trend will persist.

Allow me to take you back to 1966 to 1981 -- a period of 15 years during which the Dow just traded back and forth around 1000 destroying more wealth than at any time since the Great Depression. Or perhaps you would like to consider the Nikkei which has not made it back to its old highs in 40 years and still trades for half its peak value. If Japan is the social vanguard of the industrialized world, where adult diapers outsell the baby ones, then perhaps this is our future as well?

Or perhaps, you will remember my own lovely experience in “responsible” investing when I happened to buy 529 funds for my kid’s college education right at the peak of the Internet bubble. The total cumulative return? 2.49%. Not per year. Total over the 12 years those funds stayed invested. Yes, I know that funds would have probably doubled had I held them til now, but I needed the money for college then. I couldn’t tell the schools -- oh please wait another five years and capital returns will be sure to kick in and I will pay your tuition in full. I am good for it.

If the market takes a swan dive from which it doesn’t come back this, I am afraid may be the fate of many investors who are blindly following the index route. Buy the f-king dip is just a strategy -- just like the turtle strategy and it will lose its value eventually. Markets are simple, but they are not easy.

Three Simple Questions Every Trader Should Ask At The Start of Each Week

Boris Schlossberg

Plan your trade, trade your plan is an old maxim in the markets that almost everyone ignores.

The reason is obvious, of course. Financial markets are the least predictable environment there is. Every day is different from the last and anything can happen at any given time. Executives at Amazon, for example, can predict within a few packages, the demand for some product from a particular zip code at a particular time of the day. This is especially true for highly consistent products like soap, or cereal, or shaving cream that people reorder all the time.

In real life demand for goods is remarkably consistent since it must satisfy physical needs that are inviolable. In financial markets -- especially in speculative ones -- demand is totally mercurial. If you still believe that currency markets exist to help corporations and investors to settle their cross-border transactions or that oil markets exist to help producers and consumers find a settlement price -- you are woefully naive. More than 97% of all activity in both markets is purely speculative in nature -- meaning it does not emanate from an actual economic need for the product. The average daily volume on NYMEX for crude oil is 22 Billion barrels of notional value. The actual daily demand in the real world? 80 Million barrels per day.

Whether this is good or bad is a philosophical question that I will put aside for now. But the wide gulf between how real world markets behave and how financial markets function goes a long way towards understanding why traders have such a hard time “planning” their business. The volatility of trading simply does not have any legitimate parallels in the real world which is why almost all “real world” business advice is worthless.

And yet… the longer I trade the more I begin to appreciate the value of planning. As traders, we can never expect the kind of control that real world business people enjoy, but that doesn’t mean we should operate by the seat of our pants as a result. This is especially true if you are trading some sort of systematic approach on a day trading basis. Day trading systems have the very big advantage of the law of large numbers. The more trades you make, the more likely the possibility that the large volume will smooth out the volatility spikes of the financial markets.

If you are trading a system here are three simple questions you need to ask yourself at the start of each week.

How many trades do I expect to make this week?
How many winners versus losers do I expect will occur?
What is the pip target this strategy will likely produce?

This is hardly the Big Data-regression-driven-sophisticated-stat analysis that exists in the real world, but it’s enough to ground you in making much better trading decisions for the long term. Just asking those 3 simple questions can tell you if you are overtrading or not trading enough. If the volatility of the markets is aiding or destroying your win ratios and most importantly if you are actually following the system that you claim to trade.

Setting expectations doesn’t mean that you are now a prisoner of your rules -- quite the opposite. It means that you can now exert a modicum of control over one of the most unpredictable human activities there is.