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Trading System Design
The Smart Profits Report: Issue #433
Wednesday, June 27, 2007
Trading System Design: Two Critical “Pre-Trade” Functions That Breed Success
By D. R. Barton, Jr.
Quantitative Analyst, Mt. Vernon Research
Who knew that an article on laundry detergent could relate to investing? As I flipped through the pages of Consumer Reports, it basically stated that you can’t expect a product that combines both detergent and fabric softener to work as well as the two liquids would do when used separately.
Simply put, trying to get one product to do two very different jobs to the best standard is too tall an order.
You can apply that theory to the financial markets, too. I hear about so many people making a cardinal sin in trading system design: They continually search for that one system or strategy that will make money equally well in all markets. Unfortunately, it doesn’t exist. The markets are more complex than that. So beware the trading system design or strategy that claims to be all things for all people.
The good news is that there is a way to attack this problem. Here’s how…
Specialized Trading System Designs Abound
There are many different trading system designs available to investors - and designers have some specialized tools at their disposal to put together trading systems where the individual components can work when they’re supposed to and head to the sidelines when they’re not.
For example, if you subscribe to the theory that “the trend is your friend,” your trend-based trading system design would work well in that kind of market. But what if the market is moving sideways? Your trend-friendly system would likely get chopped to pieces. Likewise, counter-trend strategies face the prospect of missing the lion’s share of big moves.
What you need are specialized trading strategies that work in specific market conditions… To build a trading system that excels in different types of specific market conditions, you have to understand that different parts of your trading system design have specific functions. And once you know your setup and entry, you can then specialize.
- Setup: The part of your trading system that tells you to “get ready to trade.”
- Entry: The part that tells you to “pull the trigger.”
Your trading system design should require that the conditions of both the setup and entry are met before you trade. That means it should identify exploitable market conditions that allow you to enter a trade with a long-term expectation of making a profit. When it does, you wait for an entry signal to initiate the trade. If you get an entry signal but the setup conditions haven’t been met, you do nothing.
Set Them Up… And Knock Them Down
Specifically, your setup and entry must identify one of two general conditions…
- High Reward-To-Risk Ratio: There is a possibility to scoop a very large gain, relative to the size of your initial risk.High reward-to-risk trading system designs usually look for very special market situations that can strictly limit risk while providing a big upside. They either need to identify explosive situations that occur infrequently, or trades that allow a lot of leeway to move around. With the latter, some trades inevitably give back profits, while others go on to make big gains. So in this world, trailing-stops are the profit-taking exit of choice.
- High-Frequency, High-Probability Trades: You can take advantage of a repeating condition over and over, with relatively high frequency and probability of success.
In contrast, you’ve got the high probability, high frequency trading system design. These systems have lots of winners but typically the wins aren’t that much bigger than the losses, because in order to generate a high winning percentage, you must cash gains in quickly. To find high-probability, high-frequency setups, you’re looking for repetitive patterns or trends that have produced gains before. These situations are almost always very different from the ones that offer the occasionally huge move. If you go this route, the profit-taking tool of choice is the profit target.
Of course, the Holy Grail would be a set-up and entry trading system design that does both: Provides high reward-to-risk ratios and frequent, high probability trades. But in my experience, when people try to design their setup and entry combinations to do perform both functions, they struggle. It’s tough to find one trading system design that is all things to all people.
Choosing Your Piece Of The Pie
So there you have it. A world that offers big gains for low risk, and one that lures you with a high probability of winning investments on many occasions. Simple, right?
Not quite. While trying to devise a setup and entry combo that provides a glimpse into both of these worlds within the same trading system design is every investor’s dream, it’s almost a sure path to frustration.
It’s often more productive, less time-consuming, and more profitable to decide on which type of investing style fits your goals better, and gear your setup and entry system to specialize in looking for that type of situation. Some investors want a steady stream of winners, while others prefer to wait for the home run hits. But if you do want to stick a toe into both worlds, consider looking into developing two different trading system designs, with each one specializing in a specific objective.
Great trading,
D. R. Barton, Jr.
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Today’s Smart Profits Action Center
- You don’t need to have a perfect trading system design… you just need to have one that gives you an edge and offers the right blend of profit potential and risk mitigation to suit your investment style. Successful money manager Tom Basso believes that you should spend half your time determining your objectives and goals before you start investing. A few key questions to ask: How much do you have to invest? What returns are you hoping to obtain? How much time do you have to execute the trading strategies? What’s your risk tolerance?
- Our goal here is to show you how to invest like a pro so you can make more money faster. So if you want to eliminate the guesswork that is a breeding ground for bad investments and get on the profit fast-track, turn to the advice of the guys who’ve proved time and time again what it takes to make money in the stock market. Follow this link to see how you can get your hands on a report that gives you 31 tried and tested wealth-building strategies - direct from the experts.
Related Articles:
- The Perfect Trading System: 3 Ways To Break The Perfectionism Trap
- Improve Your Investing Results: Your 8-Step Checklist To More Successful Investing
- Stock Market Index Trading Strategy: A 2-Step Approach To A Successful Trading System
The Chart Of The Week
Selling Apple (Nasdaq: AAPL), let alone shorting it, is one to most difficult tasks in the investing world. But today, AAPL has broken a strong trend line and plenty of industry insiders are punching some considerable holes in the iPhone’s seemingly impermeable shell. Is this just another small pullback in AAPL’s march toward 200? Or is this the first real speed bump that Jobs & Co. have seen in years? We’ll see how many folks are willing to shell out five or six “C notes” and switch mobile carriers to AT&T/Cingular just for the privilege of owning an iPhone… Sphere: Related Content
