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9.5 Steps to Finding the Right Trading System for You.

April 24, 2006

 

With the preponderance of online search engines, Internet chat rooms and e-mail, individual investors are in the envious (or unfortunate) position of being able to find the "next best thing" or "ultimate trading system" with just a few strokes of the keyboard. But here's the rub — Out of all these supposedly great systems, only a handful actually survive and spell success for real people trading real money. So which trading systems are worth a look? And how should you go about finding a system that's right for you? Here's a list of 9½ specific steps you can take to find the right system for you.

#1 - Don't Try to Reinvent the Wheel The first step to finding a good trading system is not to fool yourself into believing you have to create it. Most investors have an entrepreneurial spirit which pushes them to think they can do it themselves; in reality, the number of hours, days and years professional developers have spent developing their wares simply dwarfs the amount of time any one individual can put toward the endeavor. If you actually believe you have the "right stuff" to develop a winning system, do be sure to send your system to a professional system-testing firm to have it put through their testing process. Any reputable firm will stress test it for you by putting in realistic slippage and commission numbers and seeing how it performs on out-of-sample data - then quickly let you know whether you have a winner on your hands or if it's merely a pipe dream.

#2 - Avoid Trading Schools, Indicator Packages and Trading Software Many so-called trading systems available today are anything but, and it is important to identify these for what they truly are. A trading school is not a system; an indicator package is not a system; and trading software programs that allow users to change the variables are not trading systems. These are not systems because they aren't mechanical, and they don't make your trading consistent. At best, they can be used by traders to create a system; at worst, they are the trading equivalent of a horoscope, always telling the naïve and needy what they want to hear. Most of these so-called systems do a very good job of showing you how a system fits onto past charts or how a certain wave pattern seems to appear again and again on the past data; however, none of the ones I have seen can actually show you how to trade these profitably in the future.

#3 - Narrow Your Search With thousands of trading systems now available, it is imperative to narrow down the universe of systems you're looking at to a more manageable number. There simply isn't enough time in the day to do a thorough review of each system, its developer, style, costs and more. The best way to start narrowing your search is by only looking at those systems which adhere to the guidelines laid out below. Create a short list of systems about which you can talk to the developer, don't have high upfront costs, and have actual results available, and you'll quickly be looking at just a handful of systems. Another filter would be to just look at the recommended systems of a system trading broker. Be wary of brokers without a recommended list, however, as they may be willing to trade any system in order to make commissions, without caring for the well-being of the hard-earned money in your investment account.

#4 - Know the Developer One rule of thumb which seems painfully obvious is the one most often broken. Actually talk to the developer of the system you are considering for purchase. Be careful of those systems that have websites without contact information. There are many websites that don't give the name of the developer, don't give a physical mailing address, no phone number, etc. These developers may be hiding who and where they are for a reason. Also beware of the hard sell and promises of profits without mention of the possibility of losses or mention of drawdowns. Ideally, if you are trading futures contracts, you only want to deal with developers registered with the National Futures Association (NFA) or Commodity Futures Trading Commission (CFTC). You can verify whether a developer you're looking at is registered by checking the NFA's background search tool at www.nfa.futures.org/BasicNet/?aspxerrorpath=/basicnet/ Search.aspx. And of course, we live in an age where there is more information than ever before available to you. Use it. Do a Google search to check websites and message boards about the system and its developer to find out what other people are saying. You may be surprised at what you find.

#5 - Avoid High Upfront Costs One of the surest signs of a trading system developer more interested in selling software than in making clients money is a very high upfront cost. Some systems sell for tens of thousands of dollars, and that is exorbitant. It just doesn't make sense to pay $5,000 for a trading system. The tendency of developers who charge a lot of money up front is to disappear after the sale. The developers charging less or relying on monthly leases tend to care more about performance, as they must have clients around for a while to earn any money. The best way to make sure a client is sticking around is to make sure he's making money. A very beneficial cost structure is a "pay-with-profits" plan. Several developers offer such programs, and you don't have to pay for the system until you have made back the price of the system in profits. There's no guarantee that you'll make any profits, of course, but it's nice to know the developer has such faith in his system that the only way he gets paid is if the system does well.

#6 - Avoid Pirated Material A corollary to watching out for costs that are too high is being cautious of costs that seem too good to be true. In particular, at all costs avoid pirated material and trading systems. There seems to be more and more of these "hacked" systems available today, and whether it is one individual or several people selling these, it is both illegal and unethical. In addition, many systems must be operated with exacting parameters, patches or upgrades, which the pirated version more than likely doesn't have. Thus, a pirated version runs a greater probability of being unprofitable. Additionally, we have heard several reports of investors who have tried to purchase pirated systems and receive nothing after payment - a true prisoner's dilemma.

#7 - Find Some Actual Trading Results What appears to work on a computer simulation can be very different than what will work once you begin actual trading, and for that reason, it's imperative you seek out some actual trading results. Actual results are the proof and, in our opinion, show a system's true colors. Whether intentional or not, there are just too many biases built into computer backtesting using past data, as you KNOW what happened. This tendency to "fit" a system's parameters to known data is called "curve fitting." One of the unfortunate hallmarks of a curve-fit system is its inability to make money in real time, with real money on the line. An easy way to combat this and find systems that are less apt to be curvefit is to find some actual trading results for the system you are interested in. Some brokerage firms post actual customer fills and the monthly profit and loss achieved by customers for different systems, and you should seek out that data as a first step. In addition, many developers trade their system personally and may be willing to show you results, or may be able to get some actual account statements from some of their other clients. Unfortunately, the grand majority of trading systems have no actual track record, instead relying on often - unrealistic hypothetical results. If you will be the first one trading a system in real time, or simply can't find any actual results for a system in which you're interested, start very slowly (one E-mini contract, for example). Then do a weekly audit of your actual trades versus the computer-generated trades for a few months. If everything lines up, you can put more faith in the hypothetical track record and trade more contracts (if that fits your money management scenario).

#8 - Beware of Adjustable Variables, Upgrades and New Versions Be wary of too many upgrades or new versions by a systems developer. The ideal situation would be a system that you "set and forget" for many years. The developers don't make much in residual income from such a system, however, and often release upgrades or new versions to mine their current customer base for some more money. The danger of a system upgrade is that it creates a different system (statistically speaking), thus rendering any prior backtesting invalid - you may as well throw out the old backtesting and start from scratch. If you invested in a system based on a Max DD of xx% and an annual return of xx% based on the backtested results - and those backtested results are no longer valid - you need to reevaluate your investment and look at a new set of backtesting. There are, however, important upgrades and patches that fix small bugs and situations to which you should definitely adhere. Just make sure they don't wildly alter the historical backtesting.

#9 - Do a Personality Test One important factor, which usually is overlooked, is whether or not the trading system in which you are "investing" fits your personality. This may seem like something more important to Internet dating than trading systems, but the better a system fits your personality, the better chance you have of long-term success. Too many times, a person who insists on seeing more winning trades than losing ones will invest in a system with a winning percentage less than 50 percent and then will wonder why this investment is not meeting his expectations. Conversely, an investor may choose a system based off of very low volatility and small drawdowns and then wonder why there isn't more action in his account. An investor needs to look past the basic performance figures when deciding if a trading system is right for him and look at the personality of the system - does it hold trades overnight, does it win on more trades than it loses, does it risk a lot or a little? Each of these seemingly insignificant factors can weigh heavily on an investor's psyche once trading is underway and threaten to keep an investor from sticking to his guns.

#9.5 - Use a Professional Trading System Brokerage Firm As the owner of a business that does just that, I obviously have a vested interest in telling you to use a professional trading system firm for executing your trading system, but the argument for doing so is still valid. On the execution side, a professional trading system firm has a room full of traders dedicated to monitoring the trading system you're looking at. An individual investor would have to sit in front of the machine throughout the day or hire someone at a much higher cost to do so. If you're thinking you can rely on autoexecution software, be very cautious of the many pitfalls and errors possible with that software. It only takes one mistake to wipe out an account. Beyond the physical requirements, a trading system broker typically has more experience, data and history with trading systems than an individual investor could gather, as well as other technological necessities - computer redundancy, multiple data streams and offsite backups, to name a few. Finally, a professional trading system firm has experience with hundreds of different trading systems and can tell investors and traders what they have seen and what they think - from an educated, objective viewpoint.

- Walter Gallwas