"When I first entered the business of coaching traders most people
thought that a trading system was an indicator."
— Van K Tharp
There are folks out there
who are obsessed with,
1) Finding the right stock
that will make them a fortune and they think there is some magic
way to do that.
2) Working on developing a
trading system to the point of perfectionism; and never getting
around to actually trading.
3) Finding the ideal
“system.”
4) Just looking for
someone to tell them what to do
Do you relate to any of
these scenarios?
Every trader needs a
strategy or system to form a framework for their trading. Without a
repeatable way to identify and execute trades, one can never be a
consistent performer. Basically your system is a roadmap
that guides your trading and keeps you from making decisions when
you are least able to do so. Meaning that trading can be
stressful. It's easy to get distracted. Life goes on regardless of
what the market is doing. If you hear news about the market changing
or you're running late for your next appointment you are not likely
to make good decisions about your trades.
However,
many people believe that a trading system is something that is
“bought in a box,” something that other people have created with
specific technical skills or secret knowledge of the markets that
they just don’t have. Well it isn’t.
There
are hundreds, if not thousands, of trading systems that work.
But most people, after purchasing a system, will not follow
the system or trade it exactly as it was intended.
Why not? Because
the system doesn’t fit them or their style of trading.
One
of the biggest secrets of successful trading is finding a trading
system that fits you personally. Developing your own system
allows compatibility with your own beliefs, objectives, personality,
and edges.
Why
develop my own system? Isn’t it easier to just go buy a system
with proven results?
When
someone else develops a system for you, you don't know what biases
they might have. Most system development software is designed
because people want to know the perfect answer to the markets.
They want to be able to predict the markets perfectly.
As a result, you can buy software now for a few hundred
dollars that will allow you to overlay numerous studies over past
market data.
Within
a few minutes, you can begin to think that the markets are perfectly
predictable. And that
belief will stay with you until you attempt to trade the real market
instead of the historically optimized market.
Many trading accounts have plummeted from this very thinking.
One “sure-thing” trade placed without proper position
sizing can wipe some traders completely out of the game.
And
what if the person peddling the system is just a great marketer who
makes their money from selling systems – not from actual trading?
How would you know?
In Van’s experience very
few people have really good systems and one of his jobs is to teach
traders what it takes to develop a complete
system for themselves. It isn’t rocket science; it just takes
commitment and the right knowledge.
You
may be thinking, “But
I don’t have the computer or math skills to create a system
myself.”
This
is one of the biggest misconceptions out there.
If
computers, math or anything mechanical terrifies you, that doesn’t
mean that you can’t determine how and what you want to trade,
which is the basis behind developing your own system. In fact,
you’re the ONLY person that really knows what will work for you.
The
key thing to remember about system development is that the trading
strategy is THOUGHT UP by you because it fits your beliefs, wants,
desires and needs. You can hire someone else to computerize your
strategy if you want to do that and can’t do it yourself. There
are plenty of programmers that will do this for you.
However,
not all trading systems have to be computerized! In fact, people
have designed and tested successful trading systems for years by
hand. Of course computers make things quicker, faster and more
efficient, but they are not necessary at all unless you need to use
computers to feel comfortable about your trading.
(If
you disagree with this, then you probably DO need computer testing
to feel comfortable or maybe you believe that when a computer
generates numbers, it is more accurate)
If
you truly understand what a trading system really is; then this will
all make sense. It isn’t complex, unless you choose to make it so!
So What Is a Trading
System?
What most people think of as
a trading system, Van would call a trading strategy that consists of
seven parts:
- Set
up conditions.
- An
entry signal.
- A
worst case stop loss.
- Re-entry
when appropriate.
- Profit-taking
exits.
- A
position sizing algorithm.
- Multiple
systems for different market conditions (if needed).
The
set up conditions
amount to your screening criteria; For example, if you trade stocks,
there are 7,000 plus 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.
For example, you might want to find stocks that are great
“value” or stocks that are making new all time highs or stocks
that pay high dividends.
The
entry signal
would be a unique signal that you’d use that meets 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 protective stop
is the worst-case loss you would want to experience.
Your stop might be some value that will keep you in the trade
for a long time (i.e., a 25% drop in the price of the stock) or
something that will get you out quickly if the market turns against
you. Protective stops are absolutely essential.
Markets don’t go up forever and they don’t go down
forever. You need stops
to protect yourself.
A 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 was 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.
The exit
strategy could be very simple. It is one factor in your trading
of which you have total control.
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. This is an important shift in thinking that you
will benefit from right now. You don't make money when you enter the
market you make your money upon your exit of the market. Far too
many people focus only on market entry, or what to buy, rather than
when to sell.
Position
sizing is that part of your system that controls how much you
trade. It determines how
many shares of stock you should buy or “how much” you should
invest in any given trade. It is through position sizing that you
will meet your objectives.
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. Many professional traders have
multiple systems that operate in multiple time frames over many
markets to help offset the enormous portfolio dependence of a single
trend following system.
___________________________________
Your system should reflect
your beliefs )i.e., who you are as a trader and as a person).
Many people are just looking for “any system that works,” but if
your trading system doesn’t match your beliefs about the markets,
you will eventually find a way to sabotage your trading.
In addition, most people
have never really taken the time to think through what they truly
want from their trading. They don’t have specific objectives in
mind. They think they
do, but they really don’t. They
just have a vague concept in their heads of “I want to make a lot
of money.” Yet,
objectives are 50% of designing a system that fits you.
Examples of possible
objectives:
1. I want to become a full
time trader making 30% per year for my clients with potential losses
no bigger than half of that.
2. I want to spend less than
three hours a week on trading and get the maximum yield out of my
system. While I’d like
to minimize my downside, I’m willing to risk whatever it takes to
get maximum returns, including losing it all.
3. I want to limit my draw
downs to no more than 20% at all cost.
With that in mind, I’d like to make whatever I can, but
minimizing the draw downs is my primary objective.
_________________________________
No system is a money making
machine that you turn on and have it print cash forever.
Systems must be evaluated and revised to adapt to changing market
conditions. And
while there are ways to measure the quality of the system, you will
never trade a system properly that you don’t feel comfortable
trading. In the same
way, you might have trouble following the advice of newsletters
because you don’t feel comfortable taking certain trades that they
recommend.
Improving your trading
performance will not come from some indicator that better predicts
the market. It comes from learning the art of trading and
understanding how to create a trading system that fits your wants,
needs, desires and lifestyle.
So ask yourself, how much
time and money am I willing to lose trying to trade other people’s
systems?
A
great trader asked me once what I wanted my system to do. I
responded vaguely about outperforming the market…. He pushed me
for the performance statistics I was after. I told him the general
statistics I was after, but said that I needed to see what the
system would do. He basically told me that I had it backwards. He
said very specifically to start with the performance I was
expecting in mind, and design a system to that specification. Wow!
– Frank Gallucci
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