Creating a trading system requires careful planning and research. However, you also have to possess the skills to build a system from the ground up. This requires advanced programming knowledge. You are going to completely count on the system in getting you in and out of trades. There will be times when you are going to be tempted to violate your own rules. I want to caution those who are interested in developing a successful system to think long and hard about your particular trading style before you begin.
The trading system will ultimately reflect your beliefs about the markets and therefore it is essential to understand that you are simply automating your trading when you develop a system.
How you see the market is exactly how the trading system is going to perceive the markets. If there is a flaw in your reasoning or research, the trading system will start with a built-in flaw that cannot be overcome without redesigning that system.
Are you able to trade off of a completely mechanical system? You might think you are but most people are not.
The majority of people cannot follow simple rules.
It is not that we do not want to follow these rules. On the contrary, we do. However, when you transition from paper-trading to real-time trading, you will be confronted with real profits and real losses. As losses mount, your mind becomes an adversary, forcing you to do the wrong thing at the worst time. “What if I am wrong” enters your mind. Your mind is telling you to stop the pain. On the other hand, when your system shows you a profit, your mind will tell you to take profits so that those profits do not get away from you. For example, you have built a stock trading system and if a particular long or short trade results in a -10% loss, your system is designed to get you out of the trade. You have back tested a variety of different stocks over several periods and you have found that a -10% loss is fairly rare. Therefore, if a -10% loss does occur, you know that something has changed and you need to get out. However, as you start seeing these percentages turn into real numbers in red, you are going to want to override your system. If you decide to throw in the towel before a loss of -10%, you will not allow your system to function properly.
The reason you create a system is to remove the panic and human emotion from trading.
You might as well continue to trade without a system if you are not going to follow the rules. There is only one approach – You have to be completely committed the rules of your system. In order to be a successful mechanical systems trader, you will have to break with most commonly held views regarding the markets. One of the most commonly held views in academia and the investment industry is the notion that there is an efficient market. When I took my first finance class, we were taught that markets have already digested all available information and it is fully reflected in the price. Therefore, it is impossible to profit from publicly available information. Let’s say that the price of a stock, futures contract, or bond incorporates all available information and I am able to devise a system that uses the daily closing prices for each to turn a profit, would that still argue that markets are efficient? I would say no. Your job as the system designer is to find and incorporate these inefficiencies into a viable trading system. There are countless inefficiencies out there and if you have the patience to do the research, you will finally discover one of these and hopefully you will be able to capitalize on it using a well thought out trading system. Remember, first you have to get into the right mindset, second, you have to acquire the knowledge, and finally, you need to have the discipline, confidence, and patience to stay with your system.