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Understand your Trading System
Wed, Oct 28 2009, 13:30 GMT
by Mike Baghdady
In today’s market, a trader’s problems change as quickly as he or she can solve them, which is why having a rule-based strategy is more important than ever, says Mike Baghdady.
In addition to trying to make correct trading decisions, new issues have arisen that we must attend to such as anonymity to protect our orders from negative selection and executing our orders with the least possible market impact.
We also have to seek liquidity and have an algorithm to help us find that liquidity; and when we do find it, we must then have a quality execution.
We should have a complete understanding of the rules behind our trading systems; we must understand why they are giving us specific signals at all times, and the reasoning behind them.
After all, what good is pulling an exceptional profit from a trade if you don’t understand the series of events that occurred to make it happen, or the ability to repeat the action consistently?
While quantitative analysts and programmers begin with certain assumptions that they believe should work, when they are tested in real life they are quickly felled by variables that the analysts couldn’t have accounted for or anticipated.
A good trader must be able to adjust their strategy to account for these variations and not only believe that the changes they have made to their strategy will stand up against a sudden change in volatility, they must also have the confidence to execute each trade with a high degree of certainty that they are more likely to win than lose.
Practically everyone makes poor assessments of risk and event probabilities under the duress, but fortunately in trading, human emotion represents a tremendous source of opportunity for us to profit from.
The best trading systems can show you a map of such human behaviour by identifying price points on their charts, flagging where traders have realised they have made errors in their judgment and are desperately seeking to act on those realisations and correct them, to limit their losses.
Within all of these price points are opportunities that winning traders know how to profit from because they understand how the errors other traders have made manifest themselves in price action.
They are making money by exploiting the consistently irrational behaviour patterns of other traders acting on their base senses of hope, fear and greed. That is why understanding price behaviour really works and continues to work because it is based on the market movements that result from this systematic and repeated irrationality that is embedded in every trader in the market.
Strategies based on price behaviour allow a trader to identify points where other traders need to enter or exit trades and to have a good mechanical system that automates the entire process of trading.
Such a system should provide answers to each of the decisions a trader has to make, and because there is a set of rules that specifically defines what should be done in any circumstance, decisions are not left to the judgment of the traders themselves, but to their systems – eliminating to some extent the risk of emotion interfering in an execution.
A profitable trading system that adheres to the rules and principles of price behaviour contains five basics elements:
- 1) Optimum Entry
- 2) Optimum Exit
- 3) Risk control
- 4) Automatic execution
- 5) Portfolio selection
It becomes much easier for a trader to be consistent in his trading if he sticks to a system he can rely on.
If a trader understands the rules behind his system, he can identify whether the market conditions are optimal under his strategy or whether they have changed sufficiently to keep him out of it.
When new variables come into the market such as volatility due a news event, or the unwinding of large positions to indentify money-making opportunities, his system should tell him that the risks are too high under these conditions, and that he either shouldn't trade or should dramatically cut his size.
When the dust settles, he should similarly be able to identify the short-term market directions based on reference points in the charts which, if executed with precision, can lead to far bigger winning trades; or in other instances, tell him to be patient and allow his trades sufficient time to develop.
Knowing the rules behind automated systems and strategies and having the knowledge and confidence that they work most of the time makes it easier for the trader to recognise all the signals and trade according to the system even during times of trading losses.
It will allow the trader to be consistent despite the inner emotional struggles they must overcome after a series of losses, or large profits.
Successful trading, whether by an individual at home or within a large scale hedge fund, is like flying a plane: you can largely travel on auto pilot but in the unforeseen event of turbulence, you can immediately take manual control and bring your position back to safety.
Published on Wed, Oct 28 2009, 13:30 GMT
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