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How To Evaluate A Trading System

There has been a lot of research into the functioning of markets and that research has spawned numerous market theories which include things like wave theory, random walk, etc. If you read stock charts or use technical analysis, you subscribe to a school of thought that it is possible to identify pricing patterns within the market (e.g., trends, Elliott waves, flags and triangles, etc.) and that those patterns can be used to structure trades once they are identified.

There are some very smart people out there that are convinced that market prices are entirely random, that it is impossible to predict market direction, and that technical analysis is a waste of time. They contend that we may think we see patterns in the market, but in reality any pattern that we might detect is no more reliable than an uninterrupted series of "heads" occurring in sequence while flipping a coin

I have even read articles and interviews of very smart folks who believe that fundamental analysis - at least that undertaken by the retail investor - is a waste of time because any information available to them is already priced into the buy and sell decisions of market participants so there is no predictive power to be found there either. This school of thought argues that predicting price is simply not possible, so investors are best serve by simply buying an index fund and then forgetting about it.

As far as I can tell, there is no definitive evidence that any one side of this multifaceted debate is rightYou must decide this question for yourself.

For those of us who choose to believe that technical trading systems can provide a trading edge, the process begins with a hypothesis. For example, you might decide that you want to trade a system using the 50 day and 200 day SMA and construct a rule set that if the 50-day SMA crosses above the 200-day SMA that you will get long the market and that if the 50-day SMA crosses under the 200-day SMA, you will exit the market and go to cash. Step two is to determine whether this idea of yours "carries water" or whether it is "full of holes." To test your theory you will then back-test the system over a period of months or years, perhaps starting with the S&P 500 as your underlying security.

Assume that you use ten years of market data. You would record each opening and closing transaction during that ten-year period. Were you profitable? How did the results compare to simply "buying and holding" the S&P 500?  Depending upon your results you might then begin refining the system - balancing between constructing a robust system versus the risk of over optimizing the system. For example, you might notice that you had some significant draw downs during market sell-offs and feel that if you shorten the moving averages it will be more responsive to changes in market direction - maybe a 20-day / 50-day moving average system or a 50-day / 100-day system. Repeat the testing. Continue to refine. On and on, until you find a system that you feel meets with your needs and expectations. From there you begin paper trading the system, then you test it under live market conditions with limited size positions.

It's a lot of work. Some people have a knack for these types of things. Some people do not.

Once you have a working trading system there are two ways to make money from it. One way is to trade the system and generate profits from your trading activity. A second way of profiting is to sell the system to others. Both are legitimate ways of earning a return on your work.

There are many, many trading systems out there. Some you can find published on the Internet, freely available for anyone who might be interested,  Other systems may cost you a few hundred bucks, and others can be quite expensive. The true cost of a system is in it's performance. A "free" system that loses money can ultimately be a very expensive trading system. Another system that costs thousands of dollars to operate may be very cost efficient if it produces profits
sufficient to justify its purchase and also produces a net return to make the time, effort and risk-taking worth while.

How do you know which systems will perform well? We can look at back-testing data, which will identify unprofitable systems but relative profitability is difficult to gauge until you actually start making buy and sell decisions with it. Anecdotal stories about profitable trades are enticing but they are no evidence of a system with long-term profitability. The way to gauge a system's potential is first through
back-testing and paper trading, followed by live market testing with small positions before transitioning into trading full-size positions.  This is true whether it is a system you've cooked up on your own, found somewhere out there on the Internet, or paid thousands of dollars to purchase.

While any trading system may be able to tout a sterling record, we can rely upon the notion that no system is right 100% of the time.  Losses are simply to be expected, which is why money management becomes such a critical factor in determining whether you are ultimately profitable with a system or not. I am not the first one to say this, but you can take the best trading system known to man and ruin yourself with poor money management while someone who is disciplined with their application of money management rules can take a mediocre system and do rather well with it.  So, whether you're trading the 50-day / 200-day SMA system or a sophisticated high priced system, keep you eye on your risk and keep your losses small.

Should you should you purchase the latest nifty trading system? That's up to you. If you're looking for a trading system and you have found one that seems to fit your needs, maybe it is worth considering.  The worse case scenarios is that you lose the money you paid and maybe a little more during live market testing - if you enforce prudent money management rules. On the other hand, you may find that the system really suits you well and produces favorable results for you.

The only thing I really worry about with most of these trading system promotions are the novice traders who jump into the market with a false belief that they are invincible with their shinny new trading system, so they wager large portions of
their capital on each trade signal.  It's only a matter of time - no matter the system - until a losing trade comes along and wipes them out. Because losing trades are inevitable, they are doomed to failure because they are overlooking the critical requirement of applying sound money management principles.

Finding or developing a reliable trading system can be a worthwhile undertaking, but only if it is combined with solid money management.  Maybe those random walk proponents are right about predicting market direction, but even they must concede that if your losses are limited and your profits are plentiful your system will be profitable.

Christopher Smith
TheOptionClub.com