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Researching and Testing Systems

Companies that have thought through their business plan often talk about their core competencies—the few functions central to the business. For a trader, developing and executing trading systems are two core competencies. For the purposes of today’s article, I would include researching and testing systems as imperative to the system development process.

The interview with Thomas Krawinkel over the last two weeks garnered a number of responses from readers. Most expressed gratitude for Thomas sharing his views and the spreadsheet tool he provided. There were other reactions as well including general agreement with his approach, curiosity, awe, and differences of opinion on his back testing ideas.

The diversity in reaction was interesting though not unexpected because traders have such a diversity of personal components. Thomas has a destination in mind, a set of resources, a set of limitations, and a lifetime of experiences that have shaped his beliefs—some are well developed and others are still forming. All of these factors are unique to him. You have a different set of factors, I have another set, and so on.

What is the Van Tharp Institute's approach to research and testing systems? In our workshops and home study courses, we cover these topics at length. However, instead of providing a specific research/test protocol, we discuss the options that traders can choose from and their advantages and disadvantages. Here are just a few of the questions we might ask of you:

  • What kind of trader do you see yourself as now or becoming in the future: mechanical, discretionary, or rule-based discretionary?
  • How will you get your initial R-multiple distribution for a new system: automated backtesting, live trading, or paper trading?
  • How much testing do you think you need before being able to trade a new system: a “lot” or a “little”?

In his preparations to trade for a living, Thomas answered these questions. By the time our Super Traders reach the system development level of their program, they also have answered these same questions and they have answered them in various ways. Some have done very extensive automated backtesting on their trading systems. Others have tested their systems with live trades only. If they have adopted a trading system and its beliefs from someone else, they may run minimal tests (if any). Nearly all of them have done their initial trading with smaller position sizing™ strategies to minimize the risk of trading a new system. There’s no “right” answer, or perhaps, stated a little more clearly: the right answers are the ones that work for you.

Currently, I’m working on a new intraday system, which will be rule based with some discretion allowed. I have arrived at an intraday system based on my understanding of Van’s SQN® scoring and position sizing concepts. The primary purpose of my trading system is to earn a high SQN score so that I can use position sizing strategies to help me meet my objectives. Several years ago, I would not have thought I would do any day-trading but doing so now fits me and helps me reach my objectives.

The basic concept for the system comes from several books by prominent traders on a set of related ideas. I am working very hard to understand why the system would work, so I am planning on minimal testing. That’s a belief I have based on one of Tom Basso’s trading principles—the more you understand the system you are trading, the less backtesting you need to do.

I intend to trade it live with small position sizes. I also intend to use a “replay” function of my trading platform to trade the system using recorded historical data. Combining the live trading results with the simulated trading results will allow me to generate a large trade sample size under different market types in a relatively short time.

However, rather than using an automated platform to generate those trade results, I will be executing each of these trades, which will create a lot more valuable information to me. The purpose of the simulated trades is as much for testing as it is for practice. By testing my personal execution of the rules, I will further my trading practice. The practice will help me gain experience and market sense to develop discretion, which I expect will help me better trade the system. Comparing the rule-based results with my trades where I applied some discretion will determine which approach is better.

Ken Long teaches that a trader’s performance executing a trading system can be compared to the performance of the mechanical application of the rule set. He refers to the actual execution measurement as the Trader Quality Number score. Traders want that number to match or exceed the SQN score of the system or else the trader is better off applying the rules mechanically. I believe a trader develops the potential to have a higher TQN score through good processes and trading experience.

Just as trading is a very broad term, so are the terms research and testing. The question is not “What’s the right way?” to research and test but “What do you require to trade a system well?”. Keep reading, communicating with other traders, and thinking to discover what works for you best—that’s part of your growth process as a trader.

Without continual growth and progress, such words as improvement, achievement, and success have no meaning.
— Benjamin Franklin

Trade well and take care.

About the Author: RJ Hixson is a devoted husband and active father. At the Van Tharp Institute, he researches and develops new products and services that will help traders trade better. While he chews his vitamins (non-chewable), he prefers to swallow his fish oil capsules whole.  He can be contacted at “rj” at “vantharp.com”.


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dr

Trading Tip

What's Driving the Markets? A Subjective View

Van has often said we don’t trade the markets or a stock or commodity, we trade our beliefs. Our beliefs are driven by memories of past events and the positive or negative feelings that we attach to those events.

My Grandpa Barton was a great example of past events affecting our beliefs, which in turn drive our current actions. Grandpa grew up in rural areas in West Virginia and the southwest part of Virginia. The son of a carpenter and cabinet maker, his public education ended after eighth grade—there was no high school and the only option was a paid boarding academy. So he went to work and eventually put himself through barber’s college. He then returned to his childhood home to open a barber shop that turned out to be a lucrative endeavor.

Grandpa was an excellent business man and the barber shop sustained him, his lovely bride and two boys through the Great Depression years. Even in the worst of times, people still need haircuts.

He was a shrewd saver and just before the Second World War, my grandpa figured that folks in the US who were just coming out of the difficult depression years would start consuming again. So he opened a general store, known back then as a “Five and Dime.” After they lived and worked through rationing programs imposed as part of the war effort, business did indeed boom after the war. Grandpa and Grandma put two boys through college, became real estate investors, and helped start a local life insurance company.

He eventually sold the Five and Dime to his protégé. The store was still in operation until just a few years ago when a Wal-mart opened up five miles away at which point another “mom and pop shop” went the way of the creative destruction business cycle.

By the time I was a young man making my way in world, Grandpa and Grandma had retired and were living in Florida for the winters. I’ll never forget him asking me to look over his investments during the post-Reagan boom years. He held everything in some form of guaranteed investment: US treasuries, FDIC insured accounts, etc.

When I asked if he had ever considered participating in the stock market with a portion of his money, he told me that he saw so many friends and colleagues lose everything they had in the depression years that he would never put money in a non-guaranteed account again.

After all of his successes, my grandpa’s actions were still driven by events that happened 55 – 60 years before.

Today’s market participants are acting in much the same way. The real estate bubble and subsequent credit debacle of 2007 – 2009 are still weighing heavily on investors’ minds.

The Toughest Game

People are acting skittish with their investing capital as every piece of news brings quick market swings. This is not all that surprising given the following:

  • Not so long ago, investors lived through a 50%+ pullback in the equities market.
  • Fixed-income positions earn almost zero returns in a yield-starved environment.
  • The current fundamentals look very negative with major risk factors that include an unstable European Monetary Union and a US debt ceiling political ping pong ball.
  • Because many fear a big drop in the stock market, they still see it as a dangerous place and retreat at the first signs of any pullback.

So investment money is running “hot” right now—moving in and out of markets with a quickening pace at every small turn. Every move up in equities, commodities, etc. has been subsequently met with an equally big pullback.

Having patience in these choppy markets where returns are hard to find is the toughest game that investors play.

My grandpa’s highly conservative style, using only guaranteed instruments, would serve him well preserving capital in this environment. But over longer periods of time, my grandfather's approach only guarantees that inflation will eat away at low-earning piles of money.

Now that we’ve looked at the anecdotal case of my grandpa, next week we’ll revisit some research into this area of past experiences driving current actions. Until then…

Great Trading,
D. R.

About the Author: A passion for the systematic approach to the markets and lifelong love of teaching and learning have propelled D.R. Barton, Jr. to the top of the investment and trading arena. He is a regularly featured guest on both Report on Business TV, and WTOP News Radio in Washington, D.C., and has been a guest on Bloomberg Radio. His articles have appeared on SmartMoney.com and Financial Advisor magazine. You may contact D.R. at "drbarton" at "vantharp.com".

Disclaimer »


Mailbag

I Don't Do Backtesting

I couldn't agree more with Thomas K in his interview in last week's newsletter.

I personally do not do any backtesting at all. I sim trade an idea for 4 months; if it is profitable, and the R-multiples and the expectancy are good, then I go live. This way, the analysis is done in TODAY's market; when the market changes drastically, say to bull quiet, and I'm not making as much profit, I will sim trade it again! Just my opinion and part of my belief system.

— Joe


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July 27, 2011 - Issue 536

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