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.

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.

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.

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.

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.

Why do we REALLY Lose at Trading?

2009 forex forecasts Boris Schlossberg

“You miss 100% of shots you do not take”. That’s a famous Wayne Gretzky statement that many trading gurus like to quote. I’ve used it myself in past columns as way to motivate traders to take on risk.

There is just one problem. It’s probably the dumbest trading maxim you will hear.

You see, trading is not like hockey or almost every other human activity out there. It has negative costs attached to every failed action.

What’s the worst thing that happened when Wayne Gretzky missed a shot? Did it ricochet off the boards? Hit the glass? Ended up in a goalies glove? To Gretzky, the downside of missing a shot was minuscule. Now imagine if every time Gretzky missed a shot, every time Lebron hit the rim, every time Messi sent the ball wide of the net, the opposing team got a point.

That’s trading.

That is what makes trading so unique and challenging. We lose not because we can’t take being wrong, but because it’s truly painful when we are.

But here is where things get really interesting.

What the most common thing we do when someone punches us?
Punch back!
So the moment we lose on a trade, we instantly get into a brawl with the market. Our trading turns into “Slap Shot”, which was a great movie, but I think we would all agree is not a good way to live life.

We can deny this all we want. We can call it “trade adjustment”. We can call it “maintaining our thesis”. But in actuality it’s just a schoolyard fight and whether we are thirty or eighty we still look like idiots rolling around on the ground trying to subdue the market which will always be stronger and meaner and dirtier than we are.

In the end, we are just left with a black eye, a puffy lip and a sense of humiliation as the money in the account is gone.

So what can we do to prevent this?

I wish I had a magic answer -- but I don’t. There is no perfect way to overcome this problem, but there are two practical solutions to that go a long way to helping contain it.

Trade smaller
Trade less

In FX one of the absolute best ways to avoid a losing spiral is to trade with no leverage at all. That means for every $10,000 in your account your trade size should be 10,000 units or less. Although FX appears to be wild and crazy, the asset class is actually the least volatile major market in the world. It rarely moves more than 1% per day. What makes it so dangerous is the high leverage that can magnify those moves by a factor of 100 or more. Losing 100 pips on no lever trade doesn’t feel like a punch in the face, more like a slight pinch on your arm and you will be much less likely to lash out at the market and want to “punch it back”. You are always much cooler and calmer when losing large amounts of pips on small leverage rather than losing a small number of pips on large leverage -- and keeping your cool is half the battle.

The other half has taken me a very long time to realize. The basic fundamental rule of the market is -- the rarer the trade, the better the trade. It seems to so obvious in retrospect yet few people appreciate that fact.

Imagine the reverse. Great trades are common! If that were true we would all be billionaires by Tuesday. In fact, if you study the actions of great traders throughout history, guys like George Soros, John Maynard Keynes, and even Warren Buffett. They resemble nothing more than the hunting habits of a lion. Basically, they spend 90% of their time doing NOTHING. And only pounce when the conditions are ideal for a score.

As day traders in FX we can’t be that choosy, but we can still be selective. If you are trading with the trend, only buy higher lows, sell lower highs. If you are fading the trend, stay as close the daily ATR as possible. You’ll be amazed at how much more accurate you will be. Instead of making 10 trades per day, do just 2 and your overall pip score will likely increase.

None of this, of course, will make you an absolute winner. You still need a strategy, an edge, an execution structure and risk control rules. But all those things can be worked out. 99% of us never get the chance to find out if we can succeed because we lose it all in a stupid schoolyard skirmish with the market. Let’s do less of that.

How to Turn Your Trading Robot into Your Servant, Rather Than Your Master

Boris Schlossberg

One of the most entertaining and thought-provoking interviews I listened to recently was a Two Blokes Trading podcast that featured Will Hunting who is really a kindred spirit of mine.

Will, who is a discretionary trader, rips apart all the conventional data driven platitudes that pass for “modern trading advice” for the retail trader. Namely, he takes issue with the idea that you need thousands and thousands of data points in order to prove your strategy “right.” Specifically, Will makes the counterintuitive point that the more data you have -- the less valuable your signals will be. Something that worked in 2011-2013 is very unlikely to work today even if the overall equity curve of the strategy is positive.

When I was a young trader I remember that like every newbie, I was enamored with rising equity curves -- the longer the better. Until one day I took a closer look at a system that was wildly positive over the past decade only to realize that it made equity highs 18 months ago and was actually slowly losing money ever since.

This death by a thousand cuts, or a lobster slow boil is the most common problem that trips up systematic traders. They do all the right things only to wind up with all the wrong results, or as Will put it in the interview, tongue firmly planted in cheek, “I have a lot of respect for professional system traders who keep going until they go broke.”

The point being that all systematic trading is the application of a static model to dynamic price action and while the model is important -- critical even -- to consistent trading success, it needs human oversight. Discretionary trading in the true professional sense is not just random placing of trades by “feel”, but the rather judicious use of your model under live market conditions. In short, good discretionary trading looks to minimize the selection of “bad” trades in your model.

Now I know that this is much harder to do than it sounds -- and it certainly requires experience and judgment, but in the end, I think it is the best way to trade.

Which got me thinking. In retail FX, we have the great benefit of encoding our trading models into MT4 EAs which do all the clerical drudgery of culling through price data to find the trades but then take every signal indiscriminately.

So one way to improve that is to run the EA on a demo account and then have the signals sent directly to your smartphone. If you like the setup you can place the trade on your real account. If not, you can pass it up. You are still using your trading model but you act as the human filter and this “pause” provides you with more control and more accuracy. It’s no panacea, but it is an intelligent way of introducing discretion into a formal trade model.