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Developing a Trading System

April 16, 2009

In my limited experience of designing trading systems and trading them, I found some key questions and points should be asked. The underlying theme of this statement is, I firmly believe building profitable trading systems is just a start. The main problem comes in the temptations to override it, tweak it and screw it up finally.Hence these questions hopefully will give an idea of psychological underpinnings, (if you closely follow your system, which is obvious) of the system as well.

Here are the key questions regarding your trading system you should ask:

  • What is your maximum system drawdown {Max. DD%}? Can you handle it? Imagine you are given 100 bucks and I take back 60 bucks from you,today and for the next ten days, keep giving you ten bucks everyday, would you be comfortable with such a situation?Comfortable great,but why?Uncomfortable,great , why? Now imagine such Max DD bucks being taken away from you. Is it okay?
  • Risk Adjusted Return % {are you happy, satisfied?}
  • Maximum Consecutive Losing Streaks. Can you handle such a losing streak? My theory is, if you have weak self esteem you might not have faith in yourself,translates to lack of faith in your own system. Hence such a losing streak might make you leave it. Can you handle the “strategy heat”?
    Dont google it, this is my self designed term, has got a calculation, but you can link it up with losing streak, maximum drawdown and the average loss percentage.
  • Recovery Factor . Is it acceptable?
  • Average Mean Adverse Excursion. Extremely important for new traders, who execute the trades manually. You have to understand and take the “trade heat” well enough, so that you don’t jump in when the trade is in 25% loss right after the day you initiate it. Is it within your limit? Is it okay to imagine this much percentage of winnings being taken away from you. Although winnings is not the right way to imagine, but my theory is if you are able to imagine giving away your hard winnings then it won’t be a problem.
  • Whats your percent winners? Profitability and winning percentage are two different things and should not be confused. In fact, profitability and win percentage is related by expectancy. Hence,one should seriously question his basic instinct of “being right” with “making money”. I have a system which makes just 17 winning trades out of 94 trades over a period of six years. But specialises in capturing huge trends, often 10-12 fold moves. The biggest winning trade lasted two and a half years. So its important to ask, and be comfortable with the winning trade percentage you would like to see, so that your psyche is able to handle that much amount of losses.
  • Did you consider fat tail events? Do you have a backup plan in case of you hit one?
  • Whats your risk of ruin? Think about it, this is too important to ignore.Is it acceptable. Now double it. Is it okay with you? Triple it? Is it okay with you. Then perhaps its alright to trade it.

Although, I have some more ideas in mind, but its important to further crystallise them before commenting here. These are the ones, I have developed and given some thought.

It is important to note that almost all, of the above is directly related to the quality of risk management and exits you follow. Tweak a bit, you might improve the RAR%, tweak a little wrongly, you will affect its profitability.

I am based in India, and here we are not allowed to engage in program trading. Hence everyday I update my data, run the program and make my trades the next day. Given the proximity of the entire process to my psychology its important for me to tweak the system not only to maximise performance but also improvise my basic comfort leanings.

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