The Trading System – Fundamentals

A trading system is a method in which a number of signals are generated to help the trader make decisions. Some of the possible signals that could be generated from a trading system are a setup for a buy signal, a buy signal, a hold signal, a setup for a sell, and a sell signal. If the system also deals with going Short on a position, then the signals would be generated inversely. More will be talked about going Short in future topics, but the concentration in this article will be going Long in a position to eliminate any confusion.

The purpose of any trading system is to make positive gains in monetary worth. There are many systems in existence that strive to achieve different goals, but all are predicated on making money. A system can be optimized for maximum gains, optimized for minimum loss (draw-down), optimized for a balance between these two goals, optimized for short term positions, optimized for long term positions, or etc. The goals of various trading systems can be as far reaching as one’s imagination.

There are many books and information available to describe trading systems and how they are tested. The most common way of testing a system is by backtesting to analyze its performance over historical data. This is a good method, but it should be kept in mind to test over various market conditions to understand it effectiveness across the various conditions. Many systems work well in certain conditions and not in others. Often one needs to use different systems for the different types of markets that are present. The problem with this is that it is usually difficult to determine if the market conditions are changing until it has already changed.

Many systems generate a variety of metrics to allow the trader to assess the systems effectiveness and the market conditions. Generating these metrics are as difficult as generating the system itself. History has shown that many bad systems have been generated over the years, and the good ones are normally only effective for certain market conditions. Risk is always a concern for the trader. He wants to minimize his/her risk while capitalizing on opportunities to make positive gains. A metric to give an assessment of risk is, there again, just as hard to generate as the system itself.

The perfect system would be a living algorithm that adapts and accurately predicts the market and the position (stock) movement to maximize gains and minimize risk. It has been said that you cannot predict the market, and in general that is true if you consider all cases. The real fact is that you cannot predict a market that has gone out of normal trading conditions. A market is in normal trading conditions over 95% of the time, and therefore it is to some degree predictable during that time. Events that cause an anomaly are such as unforeseen changes in the economic situation, world wide or local catastrophes, large companies doing improper things that come to light that have a perceived impact to the market, trading/investor radical change of confidence in the market, and many others. But after a market adjustment, it goes back to normal trading. This doesn’t mean it will go back to where it was before the adjustment, it simply means that it goes back to a normal pattern. This pattern can be, and normally is, different from the pattern that existed before the adjustment. In terms of normal market changes, they are reasonably predictable or readable.

The term “indicator” is used quite often to describe various market conditions. There are fundamental indicators, economic indicators, and technical indicators. In all of the market downturns and crashes in the U.S. markets in its history, the indicators have told the story that the market is doing this. The problem is that most traders/investors ignore the signals and loose a lot of money. A good trading system is suppose to help you maximize your gains, minimize your loses, and take the emotion out of the decision process.