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What Is a
Trading System?
By Van K. Tharp, Ph.D.
Beginning traders and investors to some seasoned
investors are constantly asking us “What exactly is a system?”
The purpose of this article will be to give you that
information as clearly as possible.
First, we’ll go through some background information to help
you understand what a system is outside of the context of trading.
You’ll learn how different people relate to systems according to
how they relate to money. The
second part of this article will focus on clearly defining what a
trading system is. The
third part of this article will focus on the broader picture of your
system—your trading plan. Finally,
we’ll focus on some key elements in system development.
Business
Systems
In Robert Kiyosaki’s book, Cash-Flow
Quadrant, he distinguishes two types of people who work for
money and two types of people who have money working for them.
In each case, one of the major distinguishing characteristics
is how they deal with systems.
First, let’s look at the idea of business
systems. McDonald’s,
as a major franchise, is basically a large set of systems that one
buys. In fact, a person
who buys a McDonald’s franchise must go to Hamburger University
for about six months (I believe that’s the length of it) to learn
the systems for operating the franchise.
There are systems for food delivery, preparing food, greeting
customers, serving them within a minute, cleanup, etc.
And all of these systems can easily be carried out by a
manager who has a college degree and employees who might even be
high school dropouts. In
other words, a system is something that is repeatable, simple enough
to be run by a 16 year old who might not be that bright, and works
well enough to keep many people returning as customers.
Now, knowing that definition of a system,
let’s look at how people in the four cash flow quadrants relate to
systems.
The Employee:
Employees are basically motivated by security.
They have a job and they do their work to get money. Employees
basically run the systems. They
don’t necessarily know that they are running a system, but that is
their function. For
example, one employee at McDonald’s will greet customers and take
their order. This
employee is basically running the “customer-greeting” system.
Most employees do not understand systems.
Instead, they just know what their job is.
And this is typical of employees who become traders or
employees who work as traders. They
typically ask questions such as “What stocks should I buy?”
“What is the market going to do?”
Or “How do I go about doing this?”
We see it all the time in the questions we get.
For example, a gentleman just called into CNBC, as I’m
writing this, and asked the guest, “What direction do you think
the market may go with respect to 'the war' and how might one
profit from it?” These
are typically employee questions.
And they amount to saying, “I don’t really understand
anything, please tell me what to do!”
The financial media thrives by answering the questions of
the employee investor/trader.
The Self-Employed Person:
The self-employed person is basically motivated by control
and doing it right. Notice
that I have often talked about how these motivations constitute some
of the biases that most traders have—the need to be right and the
need to control the markets. The
self-employed person is the entire system.
They are basically running on a treadmill only they don’t
know it. And the more
they work, the more tired they get.
Like the employee, the self-employed are
working for money. However,
they like it a little better, because they are in charge.
They think working harder will make them more money—and to
a certain extent it does. But
mostly, working harder gets them tired.
Nevertheless, they continue to plough forward thinking that
they are the only ones who can do it right.
As I said earlier, the self-employed person
basically is the system. And
quite often they cannot see the system because they are so much a
part of it. They are
stuck in all the details. In
addition, they have a strong tendency to want to “complexify”
things. They are always
looking for perfectionism and they believe that the perfect system
must be complex. They
are always asking, “What will make my system perfect?”
A lot of people come into trading from the
self-employed mentality—doctors, dentists, and other professionals
who had their own small business in which they were basically all of
the systems in one. This
is all they tend to know and they approach trading the same way.
They keep adding complexity “until it works,” even though
this strategy seldom works. The
self-employed person would be likely to have a discretionary system
that is constantly being changed.
The Business Owner:
A good business owner should be able to walk away from the
business for a year and come back to find it running better than
before. While this is an
ideal type of statement, it has some theoretical truth to it.
This should occur because the job of the business owner is to
design a group of systems to run the business so well that his
employees can do the job by themselves (or at least with a manager
in place). In other
words, the business owner is someone who designs systems and these
are usually simple systems.
The business owner usually does very well in
the trading arena if they approach the process the same way that
they’ve run a business before.
And, of course, the business owner would usually hire someone
to run their trading system, at a much lower wage.
When Tom Basso,1 who is interviewed in The New Market Wizards, did
workshops with me, he always described himself as a businessman
first and a trader second. Part
of Tom’s perspective was to look for repetitive tasks that a human
being in his organization has to repeat over and over again.
When he found such tasks, his job was to develop a program to
take that task out of human hands.
Routine computer programs are great examples of simple
systems.
The Investor:
The last person on the quadrant is the investor. The investor is someone who invests in businesses and his/her
most important criterion should be, “What is the rate of return of
the business?” In
other words, this person is continuing to ask, “If I put money in
this investment, what kind of return will I get on it?”
High return investments (e.g., high returns on equity) are
typically good businesses in which to put your money.
Robert Kiyosaki describes this as the quadrant
in which money is converted to wealth.
Rich people, according to Kiyosaki, derive 70% of their
income from investments and 30% or less of their income from wages.
Most traders are probably not investors by this
definition. They buy low
or sell high, trading stocks. As
a result, there is something they must do to generate their money.
Investors, in contrast, are people who typically look for
places where they can put their money that generate rates of returns
of 25% or higher without them doing anything.
If you know how to get those types of returns, then you want to
hold onto those investments as long as possible.
Many high tech stocks were showing earnings growth rates of
well over 25%, and when they did, the prices went up dramatically
because this is what investors want.
The problem with such investments is they are not guaranteed
to continue forever. Many
of you have probably discovered that in the last few years.
What is a Trading System?
What most people think of as a trading system,
I would call a trading strategy.
This would consist of eight parts:
-
a market filter
-
set
up conditions
-
an entry signal
-
a worst-case stop
loss
-
re-entry when it is
appropriate
-
profit-taking exits
-
a position sizing
algorithm, and
-
you might need
multiple systems for different market conditions.
A market filter is a way of looking at
the market to determine if the market is appropriate for your
system. For example, we
can have quiet trending markets, volatile trending markets, flat
quiet markets, and flat volatile markets.
And, of course, the trending markets can either be bullish or
bearish. Your system
might only work well in one of those market conditions.
As a result, you need a filter to determine whether your
system has a high probability of working. Should you trade your
system or not?
The set up conditions amount to your
screening criteria. For
example, if you trade stocks, there are 7,000+ stocks that you
might decide to invest in at any time.
As a result, most people employ a series of screening
criteria to reduce that number down to 50 stocks or less.
Examples of screens might include William O’Neil’s
CANSLIM criteria2 or a value screen for stocks with good PERs or a good PEG
ratio or a fundamental screen having to do with management and its
return on assets. You
might also have a technical set up, just prior to entry such as
watching the stock to go down for seven straight days.
The entry signal would be a unique
signal that you’d use on stocks that meet your initial screen to
determine when you might enter a position—either long or short.
There are all sorts of signals one might use for entry, but
it typically involves some sort of move in your direction that
occurs after a particular set-up occurs.
The next component of your trading system is
your protective stop. This
is the worst-case loss that you would want to experience and it
defined 1R (or your initial risk) for you.
Your stop might be some value that will keep you in the stock
for a long time (e.g., a 25% drop in the price of the stock) or
something that will get you out quickly if the market turns against
you (e.g., a 25 cent drop). Protective
stops are absolutely essential.
Markets don’t go up forever and they don’t go down
forever. You need stops
to protect yourself. As
I said in Trade Your Way To Financial Freedom, entering the
market without a protective stop is like driving through town
ignoring red lights. You
might get to your destination eventually, but your chances of doing
so successfully and safely are very slim.
The fifth component of a trading system is your
re-entry strategy. Quite
often when you get stopped out of a position, the stock will turn
around in the direction that favors your old position.
When this happens, you might have a perfect chance for
profits that is not covered by your original set-up and entry
conditions. As a result,
you also need to think about re-entry criteria.
When might you want to get back into a closed out position?
Under what conditions would this be feasible and what
criteria would trigger your re-entry?
The sixth component of a trading system is your
exit strategy. The
exit strategy could be very simple.
For example, it might simply be a 25% trailing stop where you
adjust the stop to 75% of the closing price whenever a stock makes a
new high. The stop is
always adjusted up, never down.
However, you may have many possible exits in
addition to a trailing stop. For
example, a large volatility move (e.g., 1.5 times the average daily
volatility) against you in a single day is a good exit.
Crossing a significant moving average (e.g., the 50 day)
might be a great exit. Technical
signals are good exits (e.g., breaking a significant trend line.)
Exits are one of the more critical parts of
your system. It is one
factor in your trading of which you have total control.
And it is your exits that control whether or not you make
money in the market or have small losses.
You should spend a great deal of time and thought on your
exit strategies.
The seventh component of your system is your position
sizing algorithm. Position
sizing is that part of your system that controls how much you trade.
It determines how many shares of stock should you buy.
A general recommendation would be to continually risk 1% of
your portfolio. Thus, if
you have a $25,000 portfolio, you wouldn’t want to risk more than
$250.
Let’s say you wanted to buy a stock at $10.
You decided to keep a 25% trailing stop, meaning if the stock
dropped 25% to $7.50 you would exit your position.
Since your stop is your risk per share, you would divide that
$2.50 risk into $250 to determine the number of shares to purchase.
Since $2.50 goes into $250 100 times, you would purchase 100
shares of stock. Notice
that you would be buying $1,000 worth of stock (100 shares @ $10.00
each) or four times your risk of $250.
This makes sense since your stop is 25% of the purchase
price. Thus, your risk
would be 25% of your total investment.
If you want to know more about position sizing, I’d suggest
that you read review Trade Your Way to Financial Freedom, and
my Money Management Report, or reivew my Position Sizing DVDs.
Finally, depending upon how robust your trading
system is, you might need multiple trading systems for each
type of market. At
minimum, you might need one system for trending markets and another
system for flat markets.
The Entire Trading System: Your Business
Plan for Trading3
Remember that I said that what most people
consider a trading system, is simply a trading strategy that should
be part of an overall business plan.
Without the overall business plan, many people would still
lose money. Let’s look at the overall context in which a trading strategy
should be made—your business plan.
I have written extensively on this subject, therefore for the purposes
of this article, the following is just a brief overview.
Here is a summary of what we consider to be
essential for a good trading plan:
1)
The Executive Summary.
This is usually the last section written.
It reviews all of the material of the plan and presents it in
summary form. It should
describe in detail the objective of the plan and then briefly
describe, without a lot of detail, how the objectives will be
achieved.
2)
A Business Description.
The business description should include the mission of the
business, an overview of the business and its history, the products
and services you provide (which is growth of capital and risk
control as a trader), your operations, operational considerations
such as equipment needed and site location, and your organization
and management of employees (if any).
All of these topics are fairly self-explanatory, but you
should take the time to write them out as part of your plan.
3)
An Industry Overview and Competition.
In the industry overview you need to look at the factors
influencing the market. For
example, Ed Yardeni in his web site lists ten major factors
influencing the market. These
include a globally competitive economy, a revolution in innovation,
wireless access to the Internet, low tech companies having access to
high tech tools and changing their businesses as a result, the need
to outsource to increase productivity, and many other themes.
See www.yardeni.com for more information.
In addition, you also need to know who/what your competition
is. Who are you trading
against? What are their
beliefs? What advantages
do they have that you don’t? What
advantages do you have that they don’t?
4)
Self-Knowledge
Section: You need to
know your strengths and your weaknesses and list them in this
section. You need to
know how to capitalize on your strengths and avoid (or overcome)
your weaknesses.
5)
Your Trading Plan Itself.
The tactical trading plan should be a part of your trading
plan, but it should also include (a) your trading beliefs that form
the basis of your plan, (b) any strategic alliances you may have,
and (c) what you plan to do in terms of education and coaching.
6)
Your Trading Edges:
I believe your trading plan should also include a listing of
all of the trading edges that you have in the market.
When you list your edges, you can review them often and be
sure that you capitalize upon them.
For example, your edges might include a) the fact that you
don’t have to trade, b) your understanding of R-multiples and
position sizing (which give people a huge edge over those who have
no idea about these concepts), c) your ability to read a level II
screen to get excellent stock trades, d) your sources of
information, e) your ability to plan well in advance so that you
have a game plan each day, f) your skill in following the ten tasks
of trading, g) your knowledge of yourself and your strengths and
weaknesses. This is just
a sample of the possible edges that you might have over the average
trader/investor.
7)
Financial Information.
This section should include three parts.
The first part is your budget.
How much money do you have?
What will the trading process cost you?
The second part will be your cash flow statement.
Does your plan make sense in terms of cash flow?
And finally, the third part will include profit and loss
statements. If you have
no trading record, you need to make estimates based on historical
testing and based on paper trading.
8)
Worst Case Contingency Planning.
Things always happen that you have not accounted for or
planned for in your trading plan.
How will you deal with these elements?
What will you do if any of these things come up?
How will you make decisions when these elements come up?
If you want more information, I have Market
Mastery newsletters that were devoted to business planning.
Developing a System
I am revisiting an interview I did with LTC Ken
Long, a systems expert with the U.S. Army.
Here’s what Ken said about developing a system:
Define Who You
Are: “Before
you conduct any planning or system design, you must have a thorough
understanding of who you are and what your objectives are.
Individual investors, private hedge fund managers, public
mutual fund managers, and trust managers will have
different dynamics, time frames, and risk profiles. This relates to
system design in that the final product must fit the circumstances
and dynamics of the group or individual.
If you jump into system design without considering these
basics, you will sow the seeds of future problems.”
Objectives:
“In trading system design, the problem is to define what
you want the system to accomplish.
With as many ideas, events, circumstances and adjustments
that occur in system development, you have to have your
objectives crystal clear in your mind.
If you don’t know where you are going, then any old road
will do.”
“Objectives give you the basis for making
choices and prioritizing actions.
This is not to say that objectives are static.
In fact, they can change as you discover either unexpected
limitations or advantages in your system as it matures.
But before you start you must have an initial set of goals
and objectives to guide you.”
Calibration:
“After the system is deployed and operational, part
of the process of calibrating the system is checking to see if the
objectives still fit the person or organization that you have
become. That’s a very
exciting part of system design.
I can’t tell you how often I’ve been part of a design
team that started with a limited set of objectives and discovered in
the “imagineering” phase that by adjusting our sights we were
able to accomplish far more for much less. But, you have to start
somewhere. If you
don’t start with objectives, you are spinning your wheels.”
I posed this question to Ken:
“This section is critical.
How will you know if your system is working or not?
What are your performance benchmarks?
What are your criteria for knowing that your system is not
working? How will you
make decisions when these criteria are met?
Will you scrap everything or just make position sizing
adjustments?" All of
these questions are critical to developing and operating a good
trading system.
How to Make Decisions Within the System
Here’s what Ken said about this critical topic:
“If you don’t work out how
you will make decisions ahead of time, then you will certainly have
to sort it out at the time of the first difficult decision.
If you make decisions on the spot, with no guidelines, you
have two problems: 1)
figuring out what to do and 2) how to do it.
And these problems must be faced under great stress and
limited time. It’s
better to calmly sort out the decision making process ahead of time
so that the decision mechanism is agreed to before hand.”
“In the Army, no plan usually survives
the first contact with the enemy, and so our goal in planning is to
develop a range of alternatives that can apply to a number of
scenarios. Through
rehearsal and analysis, we know which strategy works best for a
given set of conditions. The
goal of strategy development is to provide the decision maker with a
menu of choices that are robust enough to cover a wide range of
contingencies.”
“In general system development then,
we look for robust, simple plans that can cover a wide range of
conditions. When you
preplan like this, you don’t try to force the world to adapt to
your plan. If you fall
in love with a strategy and become emotionally invested in making it
work no matter what the market or the world says, you lose the
ability to adapt and learn.”
“A real world example for a trading
system might be a trader who decides to check his actual trading
performance every month against the calculated system expectancy,
and determine the statistical significance of the variation.
He might decide that any result greater than one or two
standard deviations is a signal to stop trading and recalibrate the
system or reconfirm the validity of the trading model and its
underlying assumptions. If
the actual expectancy is close to the predicted expectancy, then the
trader knows he’s on target. In
modern manufacturing systems this concept is called “Statistical
Process Control.”
“It lets the system controller know
when the production machines are drifting out of tolerance and
degrading the quality of the output to the point where the line is
stopped and the machines are retooled.”
I asked Ken about how his advice applies in
view of the fact that many trading systems are automated.
Here’s how he responded:
“It’s a general problem of the
information age, which provides us with a wide range of automated
decision support systems that can compile massive amounts of data,
analyze and process it, and present us with decision packages for
action based on criteria that we can specify.
I use a lot of these. However,
the key to making them work is to make sure that you understand the
underlying business model and system logic.
When you do things automatically by computer, you need to
understand what the computer is calculating and filtering.
I won’t use power tools until I know how they work and I
have mastered their use in simulations.”
“If you have done all the preparation
work that you outlined in your system design workshop,4 and
you have chosen indicators that provide you the right signals for
making your trading decisions, then the right thing to do is to rely
on the signals to make your decisions.
Periodic calibration of the system, however, is still
necessary to confirm that you have chosen the correct signals and
that your actions are correct. If
you have not done that work though, it may be the case that you
simply picked up the latest hot indicator and are using it
regardless of how appropriate it may be for your trading system.
If it fails to work as advertised, you are likely to dump it
for the next hot idea that comes along.
Then you’re not a system’s trader, you are only reacting
to advertising.”
Notes
1.
We have two newsletter back issues in which we
interviewed Tom Basso for those of you who would like to know more.
Call 919-466-0043 for more information.
2.
William O’Neil,
How to Make Money In Stocks.
New York : McGraw-Hill, 1987.
3.
We have an audio program on business planning for
traders that takes you through the development of a business
plan.
4.
The workshop Ken is referring to is the, How to
Develop a Winning Trading System That Fits You workshop,
which we offer once or twice each year.
About the Author: Trading Coach Dr. Van K
Tharp, is widely recognized for his best-selling book Trade Your
Way to Financial Freedom and his classic Peak Performance
Home Study Course for traders and investors. Visit him at www.iitm.com
for a FREE trading game or to sign up for his FREE weekly
newsletter.
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