Trading
Systems 201
If you haven't done so already, please read the
Trading Systems 101 article here.
System
Diversification
While splitting money between
different systems is great, just how related is each system to
each other?
For example, what
if I had a few systems that bought breakouts in different
time-frames? So system 1 might buy a 10-day breakout, and system
2 might buy a 20-day breakout. Is this really a good strategy?
My experience says no.
I like to use different styles for
each system. That makes the correlation much lower. For example,
the Smart Money uses data that has nothing to do with price. The
Breakout system buys breakouts (although it's more complicated
than just an n-day breakout). PT2 buys ahead of a breakout.
Breakdown shorts breakdowns. Base Hit buys on a dip.
By throwing these different styles
into the mix, you can often have a system zigging while the
other zags. This makes for a much smoother equity curve.
Side note -
I believe this is while Richard Dennis had a tough time getting
investors to stay with him later in his career. He made huge
amounts of money, but the drawdowns were large, and he did not
diversify between system styles I believe (can't say for
certain, but Curtis Faith, one of the original Turtle Traders
was only taught two breakout systems when he was trained by
Richard and Bill).
Knowing When to
Fold 'Em
One important question most system
designers fail to ask themselves is just when to stop using a
system? After creating systems and using them in the real world,
I know from experience that there are times when a system just
isn't working.
For example, I might create a
system with more than a dozen years of back testing and
thousands of trades. Without warning, the system might start
trading sideways, or enter into a normal drawdown and then never
recover. A year later, the system acts like normal and goes
straight up for several years.
These things are cyclical I've
found. I remember several years back when traders were talking
about the death of trend following. There was a drawdown for a
couple years, but then those systems started putting in stellar
gains. Currently, trend following in futures is behaving poorly
again. Nothing new here.
What I have done to combat this is
pretty simple really. I keep track of the individual equity
curves of each system. If one fails to meet my criteria (which
could be as simple as a long-term moving average of the system's
equity), I take it out of the mix. When it starts working again,
I "re-hire" it so to speak and put it back into the mix.
Advanced
Statistics
When
I first read about some of the traders out there making a
killing in the stock and futures markets, I had to wonder how
much of their success was due to being in the right place at the
right time. For example, what if some of the famous trend
traders like Richard Dennis or Ed Seykota didn't start trading
during the huge commodity bull market?
A
random look
The
answer to this question can be seen if we take all our trades,
and randomly scramble them up to produce several thousand
different equity curves. Some equity curves might start off with
50 winning trades in a row, or some could pick all losers.
Creating
these random equity curves is called a Monte Carlo simulation.
In
the above example, 100 lines were drawn onto the graph. The blue
line was the actual equity curve, while the grey lines were
randomly scrambled equity lines based on the trades generated.
When
I run a Monte Carlo simulation, I actually run 4000 different
equity curves. Such a huge number a samples can allow me to make
new observations. For example, I can now find what the annual
growth rate of the top 90% of equity curves was. If 3600 of
those equity curves made more than 40%, I have a 90% confidence
level that the CAGR will be 40% or greater per year. The future
is never known with absolute certainty, but this kind of
simulation really dives into the efficacy of a trading system.
You
can run a Monte Carlo simulation on just about any statistic you
want: MAR, max drawdown, longest drawdown, etc.
As
you can see, there's quite a bit of research and development
that goes into not only making trading systems, but actually
trading them. This is how professional hedge funds manage
trading systems. The more you treat trading as a business, the
more successful you will become.
Happy
Trading!
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Article: Trading Systems
101
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The results listed herein are based on hypothetical trades.
Plainly speaking, these trades were not actually executed. Hypothetical or
simulated performance results have certain inherent limitations. Unlike an
actual performance record, simulated results do not represent actual trading.
Also, since the trades have not actually been executed, the results may have
under (or over) compensated for the impact, if any, of certain market factors
such as lack of liquidity. You may have done better or worse than the results
portrayed.
